Share buybacks. At first glance – it’s just a headline we read or a financial statement disclosure or event that a company/entity goes through. As an investor, some of us may not even know what that means, what the transaction entails or why companies even perform such a program – buying back shares, what? As of late, the Dividend Diplomats have discussed share buy backs in the IBM purchase, the November stock watch list, as well as DOW Chemical unleashing dividend value. I am going to make this post a very informative and illustrative piece for all of us. Let’s share the buyback event.
Terms & Definition
By definition of the Share buyback program – Share repurchase is usually an indication that the company’s management thinks the shares are undervalued. The company can buy shares directly from the market or offer its shareholder the option to tender their shares directly to the company at a fixed price. The company is essentially using its own shares to buy back shares. This reduces the amount of outstanding COMMON shares to the public and thus increases a current outstanding shareholders percentage of ownership into earnings. Why does the company buy back their shares? Good question and here are a few answers. The company may feel their own shares are undervalued. However, that is not always the case as may be to solely improve its financial ratios where the market is targeting (earnings growth, payout ratios, etc..). Let’s do an example of different ratio impacts.
Earnings Per Share Impact
To begin, one of the dividend diplomats is the price to earnings ratio within our stock screener, which is ultimately impacted by earnings per share. I will illustrate the impact on earnings per share during a buyback.
Example: Company XYZ earnings $1,000 per year with 1,000 outstanding common shares. The earnings per share will be $1,000/1,000 or $1 earnings per share. The stock trades at $15.00 on the market, the price to earnings is also 15.00. Now the company announced it will buy back its shares as they have idle cash and believe their stock is undervalued. The company stated it is going to buy back 100 shares or 10% of shares outstanding. End of next year occurs, the company made another $1,000 and it now ends with 900 shares. The earnings per share is now: $1,000/900 or $1.11 per share, whoa! Earnings grew by 11% year over year – the market is loving it and is pumped for it, and will still trade at a 15 multiplier so $1.11 X 15 = $16.65 per share – so you’re stock just went from $15 to $16.65, not bad huh?
To conclude her: share buybacks allow management the ability to show earnings grow, which ultimately “should” increase the share price to higher amounts given the earnings multiple. Let’s slide into the next topic – payout ratio, another stock screener attribute.
Payout Ratio Impact
Continuing with the example above, Company XYZ in that first year paid a $0.40 dividend annually. Given the earnings per share before the buy back, the payout ratio would be $0.40/$1.00 or 40%, which falls in line with our stock screener metrics! Sorry I digress… it feels like I am evaluating/analyzing a company right now (this example reminds me a lot of IBM, which you can see discussion for that at this page).
To get back on point.. the company bought back 100 shares as discussed earlier and EPS is now $1.11. Therefore, given if the dividend remained stable, at this point, the payout ratio would be $0.40/$1.11 or 36%, also known as a better/lighter payout ratio as more room is now there to either: (a) increase dividend or (2) reinvest back into the company. The company can announce a whopping 10% dividend increase to go along with this, to go from $0.40 to $0.44, and this still gives a payout ratio of less than 40%, as it is 39.6%. This is similar to what DOW has announced in Bert’s article where they announced not only an increase but also a further increase to their share buyback program!
Why is this essential to Dividend Investors?
To conclude – the share buyback program is essential to dividend investors for a few reasons: It reduces payout ratio given the earnings per share increases if earnings remain at least stable. This then allows the company to continue to fulfill its current dividend to shareholders and also could allow for further increases to their dividend as well. Additionally, this instills confidence into shareholders majority of the time, as the company may believe their share price is currently undervalued and they want to further show their importance in providing further shareholder value.
This is a large reason why I have been monitoring share buyback programs as of late, as I know the large impact it has on the stock evaluations we perform, the impact of the stock prices (see how much our portfolios have grown!), as well as allowing for larger than normal dividend increases given a strong earnings environment. I love share buy back plans for strong dividend players, such as IBM, Chevron and others, aka some of the names we just announced on our November Watch List – part of the reason why they are on there! I wanted to provide a brief lesson to what this means as an investor, a new metric/fundamental/event to evaluate on a company, as well as a good knowledge tool to evaluate what really is going on with the share buyback program and the impacts it truly has.
What are everyone’s thoughts on this? Do you look into the share buyback programs? Does it cause you to invest more or less? Do you just forget about them? Would love to hear your comments and responses, as well as questions. Take care everyone and talk soon! Happy Investing.
-Lanny
-(compliments to Forbes.com for image)