Published:  August 10, 2007

Over the past couple years, it seems that hardly a day has gone by without a company announcing plans for a major stock buyback -- the very act of which often drives its shares sharply higher. In fact, if there was a giant scoreboard that tallied up the total amount of cash public companies spent on share repurchases, it would have flashed an incredible figure of $432,000,000,000 last year -- for S&P 500 firms alone.

But what exactly are stock buybacks (also called share repurchases), and how can you actually profit from them?

How Stock Buybacks Work
First, it helps to go back to the basics: a share of stock represents ownership in a company. For example, if you own 10 shares of a company that has 1,000 shares outstanding, then you essentially have a claim on 1% of the firm. Should the number of shares rise for any reason, then your stake would be diluted. Buybacks do the exact opposite by removing outstanding shares and boosting your proportional ownership in the company. Should the number of shares drop from 1,000 to 800, you would then own 1.25% of the company, significantly increasing your slice of the pie. Consider the example for a fictional company below:

Suppose this hypothetical company decides to spend $5 million on share repurchases. At the current price of $20 per share, that would reduce the outstanding share count by 250,000 shares. As a result, the firm's earnings (and cash flows, etc.) would rise on a per-share (EPS) basis -- in this case from $0.50 to nearly $0.53 per share. In other words, the company's EPS would have climbed +6%, even without a single penny of additional net income.

So by thinning out the share base, buybacks can dramatically boost EPS growth -- a key driver of stock performance. Of course, this would make the shares more attractive in the eyes of investors because suddenly the stock then trades at a more affordable earnings multiple. And because assets and shareholders equity have both been reduced, key metrics like return on assets (ROA) and return on equity (ROE) would, by definition, also improve.

Over time, buybacks can lead to other benefits as well. For one, supply and demand influences stock prices, so if supply shrinks while demand remains constant, then investors can reasonably expect to see higher share prices. Also, by specifically choosing to repurchase shares instead of pursuing other options, a company's management sends a clear message that it believes the stock is undervalued and makes a compelling investment. A buyback also sends the message that management is confident about its future cash flow generation and fundamental prospects. Of course, Wall Street is well aware of all this, which is why the very announcement of a share repurchase program can send a stock immediately higher -- giving shareholders a jump-start even before the real benefits begin to materialize.

Over the years, the average stock buyback program has removed about 5% of a given company's outstanding shares. The vast majority (about 90%) of those shares are simply repurchased on the open market at prevailing prices. However, on rare occasions they will be bought back through a tender offer.

Once the shares have been bought back, they are often simply cancelled -- meaning they can no longer be traded. Others, however, will be reclassified as treasury stock on the balance sheet and can be reissued at a later date. In either case, the shares are effectively taken out of the picture.

Harnessing the Power of Stock Buybacks
Fans of stock buybacks have had plenty of reasons to cheer lately. From early 2002 through late 2006, S&P 500 firms logged 18 consecutive quarters of healthy double-digit growth. That has left corporate America awash in profits -- more than $3 trillion in total over the past four years. Of course, many companies have used some of that money to pay down debt, fund acquisitions, or simply plow back into the business. However, there is still plenty of excess cash lying around to return to stockholders.

But not all buybacks are created equal, and sometimes they aren't as shareholder friendly as they seem. In the earlier example, suppose the stock climbed from $20 to $40 per share, and then the company's board authorized an additional $5 million in repurchases. At this point, the same outlay would now only buy back 125,000 shares.

Clearly, this second repurchase program would be much less effective. In fact, depending on the after-tax cost of capital used to fund the buyback, the repurchase may even have a negative impact on EPS -- rare, but mathematically possible. For a buyback to be an efficient use of capital, the shares must be undervalued to begin with. The more undervalued, the greater the rate of return and the more economic value provided to shareholders.

Unfortunately, a few companies conveniently ignore this fact. Some unscrupulous managers use buybacks as a means to boost temporarily a stock that is going nowhere. Others (whose compensation is often tied to certain profitability metrics) pump money into buybacks to mask poor performance and improve the firm's numbers -- and fatten their own paychecks. It's always a good idea to consider the company's motivation for the buyback, its capital structure, management's commitment to the company, and the bigger trend in the company's share count.

So how can you smoke out the good buybacks from the bad? Start with StreetAuthority's monthly Half-Priced Stocks newsletter. In a recent issue, Editor Nathan Slaughter dove into the subject of stock buybacks, including what factors can help you determine the true motives behind a firm's repurchase plan. In addition, Nathan delivered the exclusive names of over a dozen stocks that are buying back stock hand over fist -- all while trading below their estimated fair value. He also profiled two of his favorite firms with buybacks, including one set to repurchase over 40% of its existing shares. To learn more about Half-Priced Stocks, including how to access this article on buybacks, please visit this link.