“Don’t be the commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply."

What are stock buybacks and why are many companies so recently attracted to them?

When you purchase a stock, you become a silent partner of that company. All decision making abilities are transferred to the CEO and the group of management employed by the company. These individuals have control over the day-to-day operations and weigh in heavily where the cash goes.

A company buys back stock using cash to increase shareholders ownership of their pie while reducing the total outstanding shares.

So, what happens to the shares the company buys back? Well, they get stored away under a heading called treasury stocks.

These treasury stocks can be used later on to be retired or sold to raise additional cash. It is important to note, these shares after repurchase are not entitled to dividends, votes or used to calculate earnings per share.

Example: if you own 100 of the 1000 outstanding shares of Michael Kors, you then own 10% of the company. When the company decides to do a stock buyback and purchase 100 shares, then the outstanding shares decrease to 900 and you now own 11.1% rather than 10%.

It sounds easy but the strategy behind this is to buy back shares at a market rate below the company's intrinsic value (NOT market cap). If bought over intrinsic value, you might want to question management’s decisions when it comes to allocating capital.

We encourage stock buyback when a company has an abundant amount of liquidity for its daily operation and multilateral functions.

Lately, many companies have engaged in the repurchase of shares and a wide range of them are buying them back due to the lack of earnings and are highly motivated in inflating the stock price without a solid reason.

Then, what is the goal here? Regardless of the amount of money being held, the repurchase price must be reasonable, and hopefully this price remains the same or drops even lower throughout the buyout program. Let’s take an example to prove our point:

Michael Kors has approximately 205.9 million shares outstanding. You own 10.29 million shares or 5% of the outstanding. The company announces a new strategy has been approved to repurchase two billion dollars of their outstanding stock during the next five years.

We want the stock to remain depressed rather than go up in price, why?

Michael Kors trades today at $39.60. If this remains constant for the next five years, the company will be able to buy back 50.51 million shares for two billion dollar. This would leave us with 155.39 million shares and your ownership will jump to 6.6%.

If the shares during the next five years traded at $70 instead, Michael Kors will acquire 28.57 million shares. This would leave 177.32 million shares and you owning 5.8%.

Now the important part. If Michael Kors has a prominent performance and earnings represents a positive, upward increase, our shares would be worth more even when the stock has declined. The intrinsic value of the shares will be higher down the line. Unfortunately, fear and doubt clouds the mind of many investors and sends them running for the nearest door.

So, next time you see a company has been doing buy backs, ask yourself, "but at what cost?"

Written by:
Alex Lopez
Posted on:
August 7, 2017