Friday, July 1, 2011

Why do companies buy back stock shares?

Why do companies buy back stock shares?

First, let me explain why they sell shares in the first place.

Companies usually need to find ways to get cash to begin their business or take it to the next level. (Although, they sometimes simply need to get enough money to pay their bills.)

A company can get money one of a few different ways:
1. Loans (usually from banks)
2. Bonds (these are really loans...but from investors)
3. Stock--selling portions (equity) of their company in exchange for money

So when a company SELLS shares of stock, they get money, but they also give up a portion of their company.

Why does a company buy back shares of stock?

They can regain control of a larger portion of their company.

When does it make sense to do this?

It makes sense to do this when the company shares are trading for a LOW price. Like you and I, a company prefers to sell their shares high and re-buy them at a lower price. The company, however, is doing this to shares of its own company.

(Conversely, they will sell their shares when they suspect that the price is higher than it should be...People are excited about the company, and they pay a premium price to get a piece of the "action.")

What does this mean for you, the investor?

When a company buys back its shares, it usually means that they think their stock price is too low. Since they are close to the company, they usually have a pretty good idea if the company is doing the right things that will lead to better news tomorrow. If they are right, then the stock price should increase later. (At that point, they might sell shares of stock, but they'll do it at the higher price. They'll get more cash while giving up the same portion of their company.)

Likely, you will benefit from this. The fewer shares they have outstanding (shares that they sold to the public WITHOUT re-buying back those shares...sort of like an outstanding loan balance), their higher their Earnings per Share become, even if they have the same amount of profit.

Example: $10 million earnings
10 million shares
= $1 Earnings per Share (EPS)


$10 million divided
5 million shares
= $2 EPS

They're TWICE as profitable now, right? (Of course, not, but many investors only look at the summary...not the story leading to that summary.) The company looks a lot better because of it, and the stock price often goes higher from this "good news."

Usually, the company has MORE profits, and they have FEWER shares. So this almost makes them look even better. More often than not, good things happen when they can buy back their shares. (Thinking: If you don't have cash, you can't buy them. If they are not a good deal/price, you probably won't buy them.)

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