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        Why Do Companies Repurchase Their Own Shares

        Views 7732022.09.21

        The hidden truth of stock buybacks: Why do companies use them?

        Updated on Mar. 25, 2022

        Recent weeks have been featuring a stock-buyback spree. $Alibaba(BABA.US)$ shares clinched an 11% increment after the e-commerce juggernaut announced its $25 billion stock buyback program. $Amazon(AMZN.US)$ jumped up 5% after approving $10 billion buybacks. $General Electric(GE.US)$ also enjoyed the favor of its $3 billion buyback program, up 3.5% during the day. There are more to come: $TENCENT(00700.HK)$$XIAOMI-W(01810.HK)$ ……

        When geopolitical issues and rampant inflation curb the stock market, stock buybacks seem to be the silver lining, uplifting lethargic stock performances with the message from companies themselves: We still believe in our stocks and think they're undervalued. But is the stock buyback a clear-cut sign for investors to jump right into the market with bid offers, or there are some hidden truths yet to be told about this open market behavior? Here's what's about to be unveiled.

        Why do stock prices tend to rise after stock buybacks?

        There are three reasons:

        1. Stock buybacks happen in the open market. When stock buybacks are implemented, the number of bid offers will increase by a fair degree, absorbing short forces that want to suppress stock prices, thus pushing share prices upward.

        2. Stock buybacks are viewed as an undervalued signal by investors. Companies will be more likely to repurchase their stocks when they are underpriced, in hopes of reissuing them at higher prices in the future. Yet this is "undervalue" signal is pretty subjective and is susceptible to investor sentiment. And sometimes companies can use the stock buyback as a cushion to offset the downfall of stock prices when their businesses are actually deeply trapped in mud.

        3. Some stock buybacks are deliberately designed to boost EPS, a critical measure used for stock valuation. Some believe that stock buybacks can reduce total shares outstanding, which is used as the denominator when computing EPS. Share prices will then shoot up along with the rise of EPS.

        These three reasons are widely held by investors, yet we only agree with the first one, deeming the second and the third one unwarranted. Here are our explanations.

        Buybacks are not a measure to boost EPS

        Take a look at the S&P 500 total shares outstanding from 2007 to 2021 depicted in the chart below. Considering the period from 2011 to the first quarter of 2020, the share count dropped 9.6% from the level near 310 billion shares to around 280 billion shares in 9 years. And the yearly percent change hovers around only -1%, which is shown in the second picture.

        Sources: Yardeni Research, RefinitivSources: Yardeni Research, Refinitiv

        Sources: Yardeni Research, RefinitivSources: Yardeni Research, Refinitiv

        That's a minimal decrease in the share count, and it has a limited effect on the increase of EPS, considering the growth rate of EPS during 2013 and 2014 is nearly 15%, and it's even higher since 2016.

        Sources: MacrotrendSources: Macrotrend

        Buybacks are driven by compensation, not "undervalue'

        We've discovered that there's a strong correlation between the S&P 500 index and the sum of buybacks and dividends.

        Sources: Standard & Poor's, YardeniSources: Standard & Poor's, Yardeni

        If buybacks are aimed at buying bargains to release the undervalue signal, then buybacks should flourish when the economy is deteriorating. Yet the reality is the exact opposite. So what's the true incentive behind stock buybacks?

        It turns out to be stock-related compensation that underpins stock buybacks. Stock-related compensation includes stock options, stock grants and warrants, etc. These are powerful instruments used by corporations to align employees' interests with those of companies. When the economy is booming, stocks prices will surge at a fast pace, making stock options more attractive to employees. Thus companies will create more compensation packages during times of prosperity in place of traditional paychecks.

        However, the total shares outstanding will increase when those stock options are exercised by employees since companies have to issue new stocks. And that will trigger the dilution of EPS. This is the statistic companies and investors are watching for. When the EPS is diluted, stock prices will take a huge hit and turn downward. Then buybacks are announced by companies in time to prevent the slide of the EPS and pull it back to the normal level.

        Stock buybacks are not a buy signal in general

        As discussed above, stock buybacks, which are typically used to offset the dilution of stock compensations, can not be served as an absolute buy signal for investors. Stock prices still are predicated on the basic business performances and the prospect of revenue and profit growth. While recent stock buybacks are stirring up a short-term increase in stock prices, it is still the fundamentals and the overall economic condition that we should focus on.

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