Stock buybacks and issuing of shares

A lot of information can be found about stock buyback programs and the issuing of shares. Most of the times, the impact on the return on investment is mentioned in these articles. Most investors think that the impact on the return on investment of stock buyback programs and issuing of shares are opposite. In this article, I would like to explain that this is not necessary the case. Besides that, I will discuss the different views on the buyback of shares and the issuing of shares by companies.

Stock buybacks

A stock buyback program is usually announced by a company. The company gives an indication of the amount that it will spend on the stock buyback program. The number of shares that will be bought is not announced. The shares the company will buy, will be bought on the stock exchange, so the then current price of the shares.

Companies can handle their bought back shares in two different ways. First, they can see their bought shares as an investment. The company then thinks it is a great investment to buy their own shares. The company wants to sell these shares at a later moment to make some investment profits. Another reason can be that the company wants (or needs) to give the shares to their managers, as part of their remuneration. When shares that are bought back will show up on the balance sheet as an investment, the number of outstanding shares on the stock exchange will stay the same. The shares are not taken of the stock market, but only changes owner.

The second possibility is that the shares are really taken off the stock market. The number of outstanding shares will be lower than before. Shares that are bought back by the company, can be re-issued at a later moment, but most likely, the free float of shares will lower.

Positive effects of stock buybacks

Stock buybacks are mostly seen as a positive signal that is given from the company to the investors. There are multiple reasons why. The first one is that the company shows its confidence in the future. Usually, the company has more and better information about its own operations and the market than individual investors or even professional investors have. This knowledge will be used in the companies advantage. When the company thinks that the prices on the stock exchange are too high, it will not buy shares on the market. The company will normally announce a stock buyback program when the shares are undervalued.

The second reason that is often being stated as a positive effect when companies start a stock buyback program, is the distribution of profits. When there are less outstanding shares, the profit per share is higher. This will have a positive effect on the valuation of the share (and on the dividends). This only counts when the company really takes the shares off the stock market.

The third reason is often underrated, but I think this is a really important one. When managers have less money to spend, they will be more cautious on where to spend the money on. When a lot of money is available, the risk on money-consuming projects or take-overs is much higher. When the money is not available, projects and takeovers will be more critically looked at.

Negative effects of stock buybacks

On the other side, there are also negative effects of stock buyback programs. First of all, the above mentioned positive effects may each have a downside. The stock buyback programs are not at all cheap. The money spend on the stock buyback programs affect the profits of companies on the short term. Investors that focus on dividends and profits per share on the short term must know this. Stock buyback programs are only interesting for long term investors.

The second negative effect of stock buyback programs, is that companies that spending money on one thing (buying its own stocks), cannot spend this money on dividends or interesting (money making) projects. Changes in the industry or new developments which can provide a chance for the company, cannot be responded to by the company. Future profits may be lost because of the inability to invest in new projects caused by the lack of money. This, in combination with the long term for which most of the stock buybacks are announced, is a real possible negative effect. Know that nobody knows the (far) future, not even the CEO's of the biggest companies.

The final reason of negative effects that may arise from stock buyback programs, is that managers do not see a better opportunity to spend the companies (your?) money on. This may indicate that cautious, reserved managers are leading the company. Another cause may be that the managers really do not see a better opportunity to generate value than buying their own stocks. Both events will cause the company to grow less than it could have done and the future profits and dividends to be lower than might be possible.

The only question that is important for investors when companies announce a stock buyback program, is: Do you want to have your money immediately, or do you see other potential benefits for yourself (future profits). When all profits are paid out to investors (in dividends) or when all profit is spend on stock buybacks, the shareholder-value on the short term may increase. But I believe that these companies find little room for expansion and finally do not have a reason to exist. I think that the main goal for companies is not to keep their profits, but to grow their profits. Current and future profits are already part of price, the growth of these profits is not.

Issuing shares and IPO's

A lot of investors think that the possible effects of the issuing of shares are opposite to the effects of the buyback of shares. Because many investors think that the buyback of shares causes only positive effects to the price of a share, they think that the issuing of shares has mainly negative effects. I don't think that this is the case. Besides that, the buyback of shares is not only positive, like i mentioned before.

Positive effects on issuing shares

The positive effects of the issuing of shares are mainly related to IPO's (initial public offerings, the first time shares of a company are traded on the stock market). These companies need money on the short term to grow and invest in projects or products. In most of the cases, venture capitalists are involved with this companies. This means the IPO is not the first round of collecting money for these companies, but it is the first round in which less wealthy people can participate in a company.

Shares that come to the stock market with an IPO, are most of the time reasonably priced. This is done because of several reasons. First of all, the company (and the bank supervising the IPO) would like to get rid of all shares of the offering. To be sure of that, the price must be attractive for investors and there must be room for higher prices. If the price is too high, not all shares will be sold and the bank or the company is stuck with shares and the expected proceeds of the shares are too low.

Second of all, it is important for companies to have a positive start at the stock exchange. When the share price drops on entry, the sentiment around the share (and the company) will not be good. It is better to start of well.

Finally, most IPO's are done by small, growing companies. So it is likely that share prices of these companies increases. Money that is collected on the stock exchange are mainly meant to finance growth. And a growing company usually gets a higher appreciation on the stock exchange. An additional requirement are positive cash flows and profits, but that should be your main requirement when investing.

Negative effects when issuing shares

More negative than positive effects on issuing shares exist. This is both true for companies that already reside on the stock exchange for a longer term as well as for companies that are traded on the stock exchange for the first time. Scientific research has proven that shares of companies that have issued shares in the last five years have a lower return than shares of companies that have not issued shares for a long time.

An explanation for the above effect can be found in the knowledge companies have about themselves and their market. Companies will never issue shares at a moment when these are rated low. Companies are more likely to issue shares when they think the price is high, and will not get higher within the near future. Sometimes, companies will issue shares when the share price is extremely low, but there will always be an underlying cause. Most likely, the company needs money to survive, which is an indication of poor performance. And I would not like to invest in poor performing companies, just because of the higher risk and probably lower returns.

Another reason for companies to issue shares is to finance big, money consuming projects or takeovers. It is important to know the motivation behind the issuing. When you know the company wants to acquire another company and needs money to do that, take a look at their track record of takeovers. Most acquisitions only destroys shareholder value. However, some companies have a great track record and are really successful when acquiring companies.

Concluding

In this article, I mentioned different reasons why companies announce stock buyback programs or issue shares. These actions will not lead to a higher or lower return by themselves, but the underlying reason may do so. When you try to find out what the reason of the stock buybacks or share issuing is, you will have an advantage on other investors. You will be able to identify bad stock buyback programs and good share issuing. This will only be positive for your return on investment!