The Upside of Downslides

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A Fool reader asked, "I know market downturns benefit people buying stock, because falling prices are like sales. But what about people just holding stock? Is there any possible benefit for us?" The answer: Yup, company stock buybacks. Imagine that the stock of PomPom.com (ticker: POMPOM), an online cheerleader supply firm, is fairly priced and trading around $68 per share. Then the market falls 10%, and POMPOM shares drop to $56. If the company has a pile of cash on hand, it can choose to buy back some of its own shares on the open market. Doing so will signal that it considers its stock undervalued and inexpensive. It will also please shareholders, as it will boost the share price.

Share buybacks increase a stock's price because the purchased shares are essentially retired. It's as though your pizza is cut into seven pieces instead of eight. The pie size is unchanged, but each slice is bigger than it used to be. If POMPOM buys back 5% of its stock, the remaining shares will be worth 5.3% more.

Of course, prudent management needs to make sure it's investing its cash as effectively as possible. It might be more profitable in the long run to use money to build more factories or acquire another company. And if a stock is overvalued, buying back shares isn't the smartest thing to do -- simply paying cash out to shareholders as a dividend might be better, in that case.

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