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Stock buybacks are generally considered a bullish signal on Wall Street. They return capital to shareholders, while declaring management's belief that its own cheap shares are its best return on investment. As long as profits remain consistent, share repurchases can even increase earnings per share, by dividing the same amount of earnings among a smaller pool of shares outstanding.
But don't forget -- a company isn't obligated to repurchase shares just because it announced its intention to do so. So don't use the announcement by itself as a reason to buy; rather, use it as a launching pad for additional research.
Doesn't Facebook (Nasdaq: FB ) do anything simple? From its road show to its IPO, the social media giant offered investors a complicated mess that allowed its stock to launch at ridiculous valuations, only to see its value cut in half. Now, with the lockup period expiring, it's confronted with the possibility of huge tranches of shares flooding the market, depressing the value further, while simultaneously facing a huge tax liability.
As a result, Facebook is forced to undertake a complicated series of actions to minimize the damage, not least of which is a roundabout $1.9 billion stock buyback. First, to calm investors' jittery nerves, CEO Mark Zuckerberg pledged not to sell any of his 500-million share stake for at least a year. Then, to similarly ease employee worries, their lockup period for selling shares will be advanced a couple of weeks, allowing them to sell upwards of 234 million shares on Oct. 29, four days after its earnings release, rather than Nov. 14.
Second in command
This presents Facebook with a big tax bill, because it's required to withhold from compensation a portion for taxes. It estimates the withholding rate is 45%, or about 101 million shares. Now, it could have initiated a secondary offering, which LinkedIn (Nasdaq: LNKD ) , Zynga (Nasdaq: ZNGA ) , and Angie's List (Nasdaq: ANGI ) did, and most other newly public companies do. That would have raised sufficient cash to satisfy its tax obligation and, in fact, Facebook had originally planned to do so. But it cancelled the offering because it would have flooded the market with even more shares, depressing the price further. That might be one of the reasons why Groupon (Nasdaq: GRPN ) has yet to initiate a secondary offering, though most analysts expect one is in the works. Its stock has lost three-quarters of its value since its IPO.
With Facebook's stock already trading at half its IPO price, it's also not all that certain the secondary would have been successful. What the social media leader settled upon was to use some of the $10 billion in cash it raised from its IPO and has sitting on its balance sheet to pay the bill, and it will remove, for accounting purposes, those shares coming out of the lockup period's ending. In essence, it's a backdoor buyback.
Learning from its mistakes
While it's a shrewd move by Facebook that's boosted the stock price by 27% since it was announced, it also underscores the failure that was its IPO. Let's just say that most companies don't initiate share purchase programs four months after going public. Yet, for Facebook, it was the best possible plan, considering the position it found itself in.
Of course, since the repurchased shares will still be available for use as grants for new awards under Facebook's 2012 equity incentive program, and with employees still massively underwater with their original grants, the likelihood that these shares will be reintroduced into the stream again remains high. This catch-and-release stock program may still weigh on Facebook's shares for some time to come.
How much is a web page worth?
At 35 times earnings estimates, Facebook still seems richly valued, particularly for a company that hasn't fully determined how it can monetize its massive user base. While charging advertisers for running ad campaigns may be a step in the right direction, there's still a lot of uncertainty around what its business model will ultimately be.
It's possible that Facebook will end up partnering with a lot of different Internet and media companies, as Fool Matthew DiLallo suggests, and that's echoed by Motley Fool CAPS member lonestar007, who points out: "Leveraging this connectedness is challenging, but not impossible, and the potential could be very large if done right."
At the right price, Facebook retains value, and I went from betting against it at its IPO to rating it to outperform the market indexes on CAPS when it hit $19 a share. The valuation is getting rich, again, but tell me in the comments box below where you think Facebook ends up hitting its plateau -- if it does at all.
In the eyes of the beholder
Facebook's foray into online deals could be another important step for a company that needs additional revenue streams. As the wildly fluctuating stock price indicates, researching a complete breakdown of the risks and potential rewards of investing in Facebook is a must for investors. Our premium report detailing all things Facebook will get you on your way. Click here to get started now.