Share Buyback
Investors put a price on stocks. They are willing to pay a certain price for that little slice of pie of ownership in a company, and that price is recalculated every second of the trading day. Generally speaking, over time, those prices are...fair, or at least fair enough. That is, they are close enough to the value that the company places on itself that the company doesn’t directly, actively try to do anything about its share price.
Structurally, companies are always trying to market themselves. But it's a rare thing when companies actively hold up 3 fingers and tell Wall Street to read between the lines. When companies flip the Street the bird, they are basically saying, “Uh…you guys are idiots. You don’t get us. Our stock is worth way more than what you’re paying for it.” So then companies basically put their money where their mouths (or fingers) are. Sometimes both. The company begins the process of buying itself back from whatever pieces are controlled, or owned, by the public. That is, it goes into the open market and starts buying back its stock, one share at a time.
Example time:
Shmegeggie.com makes gummy-shaped candies in weird, semi-erotic shapes. A recent dental rating came out which stated that Shmegeggies were terrible for your teeth and people should not eat them. (It came from that darned 5th dentist who never recommends Crest Toothpaste.) Under this news, 14 of the 6,000 stores who sell shmegeggies...pull the shmegeggies from their shelves, costing the company maybe a penny a share in earnings. So instead of earning a dollar and a penny this year, they’ll only earn a dollar.
Big crisis in the press for like 30 seconds, and then…NBD financially, i.e. nobody cares that shmegeggies are bad for you. They are the chewy version of cigarettes and Kim Kardashian.
The stock, however, goes from trading at $25 a share to just $8 a share under a daily deluge of negative blogs from school mothers who swear they’ll never buy shmegeggies again. The company has no debt and $4 a share in cash and no big capital expenditures (like a needed shmegeggie smelting machine factory on the horizon). The company doesn’t need all the $4 a share. It generates about a dollar a year in cash, so at the very least, it decides to immediately buy back 20 percent of its shares outstanding, happy to put to work a few dollars a share of cash it has on its books.
With 100 million shares outstanding and a market valuation of 800 million bucks, the company files a special form called a 10b5-1 form, which says that they will buy back every share they can, up to $200 million worth, for $8 a share or cheaper. Mothers and angry dentists continue to negatively blog about shmegeggie.com, and the stock stays cheap at $8 a share or less. So the company is able to buy back $200 million divided by 8 bucks a share, or 25 million shares, when finally the negative stories go away, the sellers of their stock have completely sold out, and the stock starts to go up again.
Only...now things are a bit different. Instead of having $4 a share in cash, the company has $2 a share. They took 2 dollars a share, or 200 million bucks, to buy back their own stock, so a bit less cash...but it’s producing a dollar a year, and in 2 years it should have more than $4 a share again, just through cash that its normal operations produce. Way more importantly, the company has shrunk its capitalization from a market valuation of 800 million bucks. It was 8 dollars a share with 100 million shares outstanding, only now, the company has bought back 25 million shares, so it went from having 100 million shares outstanding to just 75 million now.
The new market value placed on the company at 8 bucks? Well, it’s $8 times 75 million, or $600 million. Cheap. Very cheap for a company expecting to have earnings of over 100 million dollars next year.
Note also what has dramatically changed here. In order to earn a dollar a share before the share repurchase, the company had to have 100 million bucks in earnings. Right? That’s 100 million in earnings divided by 100 million shares of stock to equal a dollar per share in earnings. But now, the company will still earn $100 million. The naysayers have all gone away, and now the company has 75 million shares outstanding...so on the same 100 million of earnings, they now earn 100 divided by 75...or $1.33 a share.
Note also that, when the company was at $25 a share before the shmeggeggie hit the fan, the equity value of the company was 21 times its earnings. That is, it was the 25 dollars a share minus the 4 dollars in cash to get 21, divided by the dollar a share in earnings. So that was 21 times the earnings for the equity value. But now, the company has bought back a fourth of its shares. Were it to return to that 21 times the equity value, that would be 21 times $1.33 to equal 28 bucks a share. It’s a lot easier to earn better than a dollar a share when they have only 75 million shares outstanding after this buyback...than it would have been with 100 million.
This is the dream scenario of share buybacks. Companies time the bottom in their own stock price, and when their price gets "stupidly cheap," they file a bunch of papers to crystal clearly disclose the details of the proposed buyback, and there ends up being a rosy shmegeggie at the end of the rainbow.