Douglas has two master's degrees (MPA & MBA) and a PhD in Higher Education Administration.
Good companies generate cash. Great companies handle that cash correctly, and there are a few different ways to do that. In this lesson, we'll discuss one of them for a publicly-traded company - buying back their own stock.
Stock Repurchase Defined
A stock repurchase is when a publicly-traded company uses its own cash to buy back shares of its own stock to get them out of the open market. When a company becomes a publicly-traded company, it issue shares of stock that individuals or institutional investors can purchase. Each share of that stock equals one little piece of ownership in that company, and, as a partial owner, whoever owns that stock has a claim on their ownership percentage of the profits generated by the company they partially own.
Why Buy Back Shares?
The market value of the company is the dollar amount each share of that company's stock is worth multiplied by the total number of shares of stock owned, by either the company or its stakeholders. Sometimes, the company has extra cash it generates through operations, and management might feel like their shares are undervalued.
Let's imagine the shares of a company that manufacturers pharmaceuticals are selling for $50 per share. If there are 1,000,000 shares owned, half by the company and half by a number of institutional and individual investors, the company has a market value of $50,000,000 (1,000,000 * $50). But, perhaps management feels like the company is worth more than that. It thinks that with the pipeline of potential medicines it has and its marketing plan, the company's worth $70,000,000.
One thing management can do to signal to the market that it believes its shares are undervalued is to buy back shares. Management of the company, just like any other market participant, can buy shares of stock. So, perhaps it dedicates $10,000,000 to buying back shares of stock. Assuming the price stays at $50 per share, management could buy back 200,000 shares.
Buying back 200,000 shares would mean there are only 300,000 in the open market (the original 500,000 minus the 200,000 that were bought back). Now, the company owns 70% of the company (700,000 shares of 1,000,000), meaning it has majority ownership. And because there is less supply of its shares out in the market, the price is higher.
A stock buyback is one thing that can be done with extra cash, and generally, it makes everyone happy. The stock price goes up, so investors are happy, and management is happy because it have more control and more wealth in stock.
Another option management has if it wants to use extra cash it has available is to declare a cash dividend. A cash dividend is a cash payment made, of a stated amount, to each shareholder, based on the number of shares they own.
Most of the time, when management declares a dividend, it is a quarterly or annual payment, and it doesn't change, or at least, it doesn't change often. But, the Board of Directors can declare an increase or decrease in the regular dividend, or if they have some extra cash, it can declare a special dividend.
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So, instead of that share buyback that was discussed earlier, let's rewind and go back to when management had $10,000,000 and 500,000 shares of stock owned by external investors. Instead of buying back shares at $50 each, management decides to declare a special, one-time dividend of $20 per share. The company wouldn't own any more shares than it had before, but it would be giving cash back to the shareholders, and announcing something like this is very good press for the company. It's likely the stock price would increase in anticipation of the $20 dividend and the belief that the company must be a great company.
The Real World
Now, with these two definitions, we can talk about some real world considerations. Do a web search for a company you like and 'cash dividend.' And if you find it actually pays a dividend, it's probably closer to 1% of the stock price, not 40% (like our example of a $20 dividend on a $50 stock). Also, when management buys back stock, it doesn't generally buy back 20% of all shares - that would cost too much.
In the real world, there are a number of important considerations before utilizing extra cash, such as shareholder expectations, internal vs. external uses of cash, market signals that are sent by either paying a dividend or buying back shares of stock, how any use would be reflected in certain metrics, and future needs of the company.
One real world consideration is related to how the use is reflected in financial metrics. An important financial metric that many investors use to identify the value of a share of stock is called earnings per share, or EPS. Earnings are equal to net income. The cash used to repurchase stock, pay a dividend, or use for some other reason can impact future earnings per share. Thus, how cash is used now might impact EPS in the future.
Companies don't only generate sales and cover their costs. They also generate cash. Management needs to decide what to do with that cash. If the company is publicly-traded, two of the options management has with excess cash are paying a cash dividend, or a cash payment for each share; or buyback shares of its own stock from other investors. Each strategy has advantages and cost, and each are appropriate if they are aligned with a corporate strategy.
EPS, or earnings per share, is an important metric that can be impacted in the future by how cash is used now. This, along with a number of other real-world factors, should impact what management does with its cash. In the end, wherever the cash ends up and whatever the result, it can be a good thing for the company.
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