If you own a shares in a company that announces a stock buyback program, you may feel it is cause for celebration. It may also be a signal to sell the stock.
A company buying up its own stock can positively impact the price of shares, and may also be a wise business move. However, there are also questions raised by stock buyback programs, and unless you are confident of the answers, you may want to use any price appreciation as an opportunity to sell.
The Economist recently reported that share buybacks have been going on at near-record volumes over the last year. One particularly telling stat: IBM spends twice as much buying up its own shares as it does on research and development. How should a shareholder feel about that?
Here is why shareholders often welcome these programs, and why a share buyback might still be a sell signal.
Why shareholders like buybacks
Buyback announcements have long been a way for management to get in the good graces of their shareholders. Here are a couple of reasons why:
- Short-term price bump. Share buybacks can boost the price of the stock, at least for a while. The company is creating an unusual and often sizable demand for the stock, and increased demand typically drives up prices.
- An insider's assessment of value. There is a view that no one knows better when a stock represents a good value than those closest to the operation and management of the company. If those who know the company best think it is a good time to buy, shareholders feel reassured.
Reasons to think about selling
Shareholders should not be unquestioning cheerleaders for stock buyback programs, however. Here are reasons for some healthy skepticism:
- A negative commentary on growth prospects. If a company looks at all the opportunities available to it -- investment in product development, capacity expansion, technology upgrades, sales force additions, etc. -- and decides that its money is better spent on buying up its own shares than on any of those opportunities, shareholders should question whether there is room for the company to grow its sales and earnings very dynamically in the future.
- No outside buyers? While it may be encouraging that management thinks the company is a good buy, shareholders might wonder if there should be some outside buyers looking to buy those shares if they are so attractively priced.
- Mixed motives. Senior management may have compensation incentives like stock options that benefit from a boost in price, or financial performance targets like earnings-per-share increases that can be artificially engineered with a stock buyback. Shareholders should question whether the buyback is in the best interests of the company, or merely good for executive compensation.
- Reduced liquidity. Buybacks are fine for companies that have built up huge stores of cash, but for those with tight cash flows they could cause a squeeze during a subsequent downturn.
- Increased leverage. If a company takes on debt to conduct a buyback, it is becoming more leveraged. Shareholders should view it as a riskier proposition as a result.
A share buyback program may very well be good for a stock today, but not necessarily good for the company's future. If that's the case, take it as a sign to sell.
This article originally appeared on MoneyRates.com.
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.