How Do Share Buybacks Affect Stock Prices?

When a company repurchases its own shares, it reduces the total number of shares held by the public, effectively raising the percentage ownership of the remaining shareholders and hopefully the share price.

At first glance, it will appear that stock buybacks create value for the company because dividing the same net income with fewer shares available in the market increases the Earnings per Share (EPS) of the stock. A higher EPS leads to a higher share price.

But a closer look at this market notion shows that an increase in EPS from buybacks does not necessarily increase the stock price. In fact, stock buybacks lead to lower valuation because cash is spent to buy the shares.

Let’s illustrate this argument with a hypothetical case using the financials of Store Specialists, Inc (SSI), which recently announced a share buyback program.

SSI earns an annual net income of P265 million and currently trades at 54x P/E. It has cash of P1.46 billion that earns around P13 million in interest income.

Imagine the company uses all its cash to buy back its shares from the market at P4.32 a share. The buybacks will reduce its total shares outstanding from 3.3 billion to 2.9 billion, increasing its EPS from P0.08 to P0.085.

Once the cash has been used up, which is presumably the safest asset in the balance sheet, what will remain in the books will be the operating assets, which are considered riskier.

Because it is riskier, the valuation of the remaining assets will get a lower P/E multiple.

Let’s assume the value of SSI at 54x P/E to be equal to the weighted sum of the P/E of cash and P/E of operating assets. The weighting shall be based on the contribution of assets to net income where cash contributes 4.9 percent and operating assets 95.1 percent.

Now, the P/E of cash can be estimated by dividing every peso of interest income with average interest rate of 0.9 percent, which results in 112x.

To determine the implied P/E of the operating assets, simply deduct the weighted P/E of cash asset (e.g. 4.9 percent x 112 P/E), which is 5.5x P/E from the total P/E of 54x. The resulting P/E of 48.5x is then divided by weight of operating assets, which is 95.1 percent, to derive the P/E of 51x.

One can see from this exercise that while EPS increased to P0.085 from P0.08 after the buyback, the P/E of the stock decreases from 54x to 51x due to the absence of cash assets.

With higher EPS against the lower P/E multiple, the target price is computed at P4.32, which is the same price before the buyback, therefore no value created.

If this is the case, then why do stock price increase with buybacks?

One reason why share prices increase is the market starts to consider the stock grossly undervalued after the company made the announcement.

The buyback signals a commitment from the company to reflect the true value of the stock and protect it from being further neglected.

Another reason that drives stock prices to go up is the company begins to flood the trading floor with buy orders for the stock.

Buybacks help provide the liquidity support to push stock prices as evidenced by the share price performance of the stocks that have ongoing buyback programs this year.

Stock buybacks for Alliance Global (AGI), for example, contributed around 6.9 percent of total trading volume that increased its share price by 15 percent from P15.04 to as high as P17.30 at one point since it announced its buyback program recently.

Other firms that raised their share price successfully, at least in the beginning, as a result of buybacks with large percentage to total trading volume include Emperador (14 percent), Global Ferronickel (25 percent) and RFM Corp (12 percent).

While increased trading demand may boost share prices, only real positive changes in the company’s fundamentals after buybacks can sustain a meaningful recovery.

Without it, any increase in share price may be temporary, which may eventually lead to a substantial correction after few months.

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Henry Ong is a Registered Financial Planner of RFP Philippines. He is one of best-selling book co-author of Money Matters. He also writes regularly as a columnist for the Philippine Daily Inquirer.

Source: http://business.inquirer.net/238377/share-buybacks-affect-stock-prices