Should you invest in companies that buy back stocks?
Share buybacks signify that stocks may be undervalued. Companies put their money where their mouth is when they see that their stocks need some boost to reflect the real value.
But buying back shares does not necessarily increase the value of a stock.
The value gained from the increase in earnings per share by reducing the total shares outstanding of a company is often offset by the loss of value due to decrease in cash.
Sure, stock buybacks increase share prices because of the liquidity effects that push the demand for stocks, but only temporarily as buy orders quickly fade away after a few weeks.
When a company buys back its own stock in the market, it is simply transferring value between its shareholders.
For example, if a stock is perceived to be underpriced, a buyback will benefit the shareholders who held on to their stocks at the expense of those who willingly sold at a 'low' price.
If a stock is overpriced, on the other hand, a buyback will enable shareholders to take profit at a 'high' price at the expense of those who chose to keep their shares.
Remember that stock buybacks can be considered another form of dividend payments since it also involves cash distribution from earnings.
When a company increases its dividend payouts from earnings, it allocates less cash for reinvestment. The lower the reinvestment, the slower the growth of the company will be.
Now, the growth consequence of stock buybacks can have different effects on the share price.
If the market thinks that the company has no more growth opportunities to pursue, a stock buyback will enable the company to return its excess cash to shareholders, which should boost the stock price.
However, if the market believes that the company is using its cash to buy back shares that would have been used for more productive investments in the future, then a share buyback can affect the stock price negatively.
How do we assess the impact of a buyback on a stock?
We can measure this by comparing the historical return on equity of a stock against its hurdle rate, which is the cost of equity.
If the company's hurdle rate is higher than the return on equity, it will have negative residual return.
We can assume the company does not have profitable investment opportunities at the moment. Therefore, a stock buyback should have a positive effect on the share price.
On the other hand, if a company has a return higher than the cost of equity, we can assume that it will forgo valuable growth opportunities in order to buy back its own shares. Hence, a buyback in this case will have a negative effect on the stock.
There are 20 companies that launched their stock buyback programs this year and half of these yielded negative residual returns due to the rise in interest rates recently.
About 80 percent of those that have negative returns saw their stock prices go up higher than their average buyback cost.
These stocks are Cosco Capital, First Gen, First Phil Holdings, ICTSI, Megawide, Phinma Corp, SSI Group and Harbor Star Shipping.
Similarly, eight of the 10 companies in the other group that have managed to generate positive residual rates had their share prices falling below their buyback costs.
These stocks are Belle Corp, Bloomberry Resort, Cebu Pacific, Concepcion Industries, Cebu Landmasters, Emperador, Global Ferronickel and Semirara Mining.
Based on this observation, at 34 percent correlation, we can say that the residual return of a stock has a negative relationship with the share performance of a buyback.
In times of rising interest and inflation, share buybacks may work best when stocks have higher risk of negative residual returns.
Just because stocks are historically cheap does not mean buybacks can always improve the share price.