What does a share buy-back mean for me?

In looking at all the different ways in which a company can produce returns for its investors, one of the more subtle methods is the share buy-back strategy. While there are a variety of reasons why it is that a company would chose this route as opposed to the payment of a dividend, or to reinvest the funds back into their operations, it is important for us to understand how it is that such a transaction will impact our personal portfolio on a number of different levels.

When a company repurchases its own shares from the open market, we can start to evaluate the impact this will have on our investment position by understanding how it is that the company is using money from its earnings, to buy back individual shares. This means that the price/earnings ratio will likely remain the same, and therefore maintain the ability of the company to continue growing on a per-share basis. This is as opposed to a situation where the company uses earnings to pay out a dividend, which will reduce the earnings amount available to the company, and then actually increase the price of the stock.

That being said, the payment will still reduce the cash and retained earning balances on the company’s balance sheet, meaning that its ability to make future investments, buy backs, or dividends is then decreased. As such, this latter point means that the company’s stock value will no longer reflect the expectation of the buy back, but will instead reflect the fact that there is less possibility for future buy backs. These two assumptions combined suggest that the value of the company will incrementally decrease in accordance to the value of the buy back, but will maintain its ability to grow in line with the company’s operations.

The second part of a share buy-back that an investor should take into consideration when evaluating the value of the company is that it will have an impact on the company’s book value of its shares. We will go into greater detail about this change later on, but for now we need to remember that there are a variety of important measurements that depend on the value of the company’s book shares. For example, the debt-equity ratio (a key measurement of a company’s leverage) can be slightly changed by the buy-back, which could either improve or decrease the risk associated with the company’s capital structure.

From there, an investor should keep an eye on the source of the funds being used to buy back the shares in question. If these shares are being purchased using funds from debt financing, we might be seeing a situation where the company is over leveraging itself in a negative way, in an attempt to inflate the stock price. Alternatively, if the company is using more money than it actually earns to buy shares, it might be that this endeavor is unsustainable, and actually hurting the financial position of the company.

We therefore need to be aware of how it is that such a transaction will impact the overall position of the company, and what it is that is actually motivating the transaction itself.