Are Your Stocks Rewarding You?
By Scott Chan
Companies can put their cash to many uses. They can reinvest it back into the business, pay down debt, buy out a competitor, etc. They also can use the cash to reward shareholders.
The two main ways they can use cash to reward shareholders are through buybacks and dividends. Let's examine the comparative merits of both avenues.
Benefits of a Buyback
As the name suggests, a buyback is when a company repurchases its shares. The company will either buy them on the open market or make tender offers to existing shareholders to buy their shares at a certain price. The repurchased shares are usually retired.
This helps shareholders by 1) supporting the share price, and 2) reducing the number of shares outstanding.
When a company's board of directors authorizes a share repurchase program, it's usually for at least hundreds of millions of dollars over time. The company acts as major buyer backing the stock.
Moreover, when there are fewer shares outstanding, each share is entitled to a bigger chunk of the company's revenue and profit. This has the opposite effect to a dilution, which decreases the ownership stake of each share.
Easy Ratio Boost
For example, let's say company XYZ has 100 million shares outstanding and it earned $100 million in net income. That comes out to an earnings per share (EPS) of $1. But if the company repurchased 10 million shares, the EPS will increase to $1.11 ($100 million / 90 million shares).
Even though the company is still making the same amount of profit, just by buying back shares, it increased its EPS by 11%. Since each share is entitled to more profits, it is more valuable. All things equal, the net effect of a stock buyback on shareholders is positive.
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