What’s Prompting the Big Surge in Stock Buybacks?

Dennis McCarthy  |

While many investors have been on the sidelines waiting to see just which direction the stock market will take, companies have jumped in as active buyers of their own stock.

So far in 2011, companies have authorized the repurchase of $453 billion of their company stock which puts 2011 in line to be the third largest year of stock buybacks on record, according to Bloomberg.

Is this a good trend or not?

For a shareholder, a company’s buyback program is generally a good thing.

A shareholder looking to sell shares will benefit from the extra demand for stock triggered by the buyback program.  A selling shareholder may get a higher sale price because of a buyback program.

Even a shareholder planning to stay put in a stock benefits from keeping the stock price up and, possibly, reducing price volatility.

The real benefit of a stock buyback program to a shareholder staying in the stock, however, is improved fundamental corporate performance, that is, presuming the company is using its cash to get the highest return on investment.

Authorizing a stock buyback program signals that a company thinks that buying back stock will produce a better return for the company and its shareholders than alternatives such as holding onto its cash or investing in additional equipment or personnel or even buying another company.

Companies holding cash recognize, just like individual investors, that the interest earned on cash today is very small.

The return on investing in additional equipment or personnel varies by company but the message implied by the high volume of buyback programs now underway is that the expected return on investment in equipment or personnel is low.

With borrowing costs at historical lows, some companies are even borrowing to pay for stock buyback programs.

What’s the math behind stock buybacks?

On a micro level, if the cost of having a share of common stock outstanding is determined to be higher than the cost of an alternative, it’s better for a company to buy back stock.

Let’s look at the math, the implied cost to a company to have a share of common stock outstanding can be calculated from its forward price / earnings or P/E ratio using next year’s projected EPS.  The implied cost of equity is the inverse forward P/E or forward E/P.

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So, a company trading at a 20 forward P/E has a cost of equity (E/P) of 5%, one divided by 20.  That’s the benchmark for our example.

What are a company’s alternative investment opportunities?  If those alternatives yield a return on investment (or cost less than) that benchmark, it’s better to buyback stock

Holding cash in the bank earns less than 1% and, at some banks, costs you money.

As noted, the return from investing in additional equipment or personnel varies by company but appears to be low based on anecdotal evidence.

Lastly, company’s borrowing rates are low, ranging from 1 to 4%, and this is before tax which would reduces the cost even more.

In our example, the alternatives are less than 5%.  This math suggests that a company should buy back shares rather than holding cash or investing it.  The company could even borrow to buy back shares.

Each company does its own calculation for its own circumstances.  The volume of stock buyback programs now underway suggests that companies’ math has a similar result to our example.

Until companies’ math changes, we’re likely to see this volume of buyback activity continue.

For questions about an “at the money” or any type of offering, contact Dennis McCarthy.

DISCLOSURE: The views and opinions expressed in this article are those of the authors, and do not necessarily represent the views of equities.com. Readers should not consider statements made by the author as formal recommendations and should consult their financial advisor before making any investment decisions. To read our full disclosure, please go to: http://www.equities.com/disclaimer.

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