Without a doubt, share repurchases are one of the best uses of a company's excess capital. Here's why I get interested anytime I hear a company's planning to buy back its own shares.
Leave it to the experts
When it comes to buybacks, I assume that management's smart enough to buy its shares when it knows they're unreasonably cheap, and only do so when there's no better use for the money at hand. Because management knows its own company very well, it's probably more accurate in valuing its own shares than assessing other ways of using capital. Making an outside acquisition requires expert knowledge of the target company, while taking on additional internal projects with unknown future payoffs is inherently riskier. But valuing its own shares simply requires a company to take a good long look at its own performance.
Give shareholders the money
There's one particularly compelling counterargument to share buybacks: Why not simply pay out the money as a dividend, letting shareholders use it as they see fit?
It sounds tempting, but I believe that buybacks are a better deal. Unlike buybacks, dividends slap shareholders with a tax bill, doubling up on the corporate taxes most companies pay. More importantly, most shareholders already believe that their holdings are undervalued. It's inherently appealing when management not only seems to agree, but puts up cash to boost that value.
On the other hand, buying back overvalued stock is a very bad idea -- but I'd hope that Foolish investors wouldn't bother buying into companies unwise enough to do so.
Instant profits
To illustrate the power of buybacks, consider this example. Say a company has 10 million shares outstanding and $200 million in cash, or $20 per share, with no other assets or liabilities. For whatever reason, Mr. Market has the shares trading at a mere $10. If management buys back 5 million shares, it will have $150 million in cash remaining, but the average value of its cash per share will rise to $30. Even though the company spent money, its repurchase just increased the intrinsic value of each share by 50%.
Of course, in the real world, it's not so simple. Companies have many more moving parts, and valuing a buyback isn't as simple as counting cash in the bank. Yet some management teams still do the right thing when their shares are ridiculously undervalued. Washington Post
As with most things, buybacks' merits depend on how they're used. In the hands of smart managers, however, buybacks can be a powerful tool to promote shareholder value.
Further Foolishness, free of charge:
- 5 More Undervalued Stocks Getting Bought Back
- The Best Buying Opportunity in 12 Years?
- The Most Important Investing Lesson of All
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Fool contributor Emil Lee is an analyst and a disciple of value investing. He doesn't own shares in any of the companies mentioned above. Emil appreciates your comments, concerns, and complaints. The Motley Fool's disclosure policy can't be valued highly enough.
