Stock buybacks boost share value

Companies frequently announce that they’re buying back some of their shares. Recently, Federated Department Stores, Comcast, Viacom and Microsoft, among many others, have done so. When a company buys back stock, it typically does so on the open market – it doesn’t buy your shares, unless you happen to be selling them. You keep your shares.

With the company out there buying shares, the stock price may pop a bit, due to an increased demand for the shares. Generally, the more shares a company buys and retires, the better off you, the shareholder, are. Imagine that Dodgeball Supply Co. (ticker: WHAPP) is divided into 100 shares. If you own 25 of them, you own 25 percent of the company. If the company buys back 50 of its own shares, then there will only be 50 shares. You’ll still own your 25 shares, though, so you now own 50 percent of the company.

That’s extreme, of course, but it’s to make a point. The more shares that are bought back, the greater your share of a company’s earnings. If Dodgeball Supply earned $100 in net income, that would be $1 EPS (earnings per share), pre-buyback. After the buyback, though, the firm would still have the same earnings, but those earnings would be spread over just 50 shares – so the EPS would go up to $2. The price-to-earnings (P/E) ratio, based partly on EPS, would fall, and each share potentially would be worth more.

If you’ve ever thought that a company should use available funds to pay shareholders cash dividends instead of buying back shares, think again. Remember that when a company earns income, it pays taxes on that. When it then pays out any dividend to you, you get taxed. So that income is taxed twice – hardly very efficient. By buying back shares, the company is still rewarding shareholders, by making existing shares more valuable, but it’s doing so in a way that does not trigger taxable events for shareholders.

Just make sure your companies’ earnings aren’t increasing solely because they’re buying boatloads of shares. Look for increasing sales or revenues, too.

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Q: What does it mean when someone says a stock is “priced for perfection”?

– T.K., Bedford, Ind.

A: It means that the stock’s price is steep – so steep that those investing in it at the current price must be expecting extraordinary growth and perfect execution of the company’s strategy. If the company were to stumble, or sales to slow, then the stock price would likely retract, too.

A very sensible way of investing is “value investing,” which involves looking for stocks that are selling for significantly less than you think they’re worth. This approach can minimize your downside risk by providing a margin of safety. Other investors look for high-flying stocks, many of which are “priced for perfection.” If rapid growth happens, the stock may continue to rise. But if not, look out.