Share Buyback
Categories: Company Management
Investors put a price on stocks. They are willing to pay a certain price for that little slice of pie of ownership in a company, and that price is recalculated every second of the trading day. Generally speaking, over time, those prices are...fair, or at least fair enough. That is, they are close enough to the value that the company places on itself that the company doesn’t directly, actively try to do anything about its share price.
Structurally, companies are always trying to market themselves. But it's a rare thing when companies actively hold up 3 fingers and tell Wall Street to read between the lines. When companies flip the Street the bird, they are basically saying, “Uh…you guys are idiots. You don’t get us. Our stock is worth way more than what you’re paying for it.” So then companies basically put their money where their mouths (or fingers) are. Sometimes both. The company begins the process of buying itself back from whatever pieces are controlled, or owned, by the public. That is, it goes into the open market and starts buying back its stock, one share at a time.
Example time:
Shmegeggie.com makes gummy-shaped candies in weird, semi-erotic shapes. A recent dental rating came out which stated that Shmegeggies were terrible for your teeth and people should not eat them. (It came from that darned 5th dentist who never recommends Crest Toothpaste.) Under this news, 14 of the 6,000 stores who sell shmegeggies...pull the shmegeggies from their shelves, costing the company maybe a penny a share in earnings. So instead of earning a dollar and a penny this year, they’ll only earn a dollar.
Big crisis in the press for like 30 seconds, and then…NBD financially, i.e. nobody cares that shmegeggies are bad for you. They are the chewy version of cigarettes and Kim Kardashian.
The stock, however, goes from trading at $25 a share to just $8 a share under a daily deluge of negative blogs from school mothers who swear they’ll never buy shmegeggies again. The company has no debt and $4 a share in cash and no big capital expenditures (like a needed shmegeggie smelting machine factory on the horizon). The company doesn’t need all the $4 a share. It generates about a dollar a year in cash, so at the very least, it decides to immediately buy back 20 percent of its shares outstanding, happy to put to work a few dollars a share of cash it has on its books.
With 100 million shares outstanding and a market valuation of 800 million bucks, the company files a special form called a 10b5-1 form, which says that they will buy back every share they can, up to $200 million worth, for $8 a share or cheaper. Mothers and angry dentists continue to negatively blog about shmegeggie.com, and the stock stays cheap at $8 a share or less. So the company is able to buy back $200 million divided by 8 bucks a share, or 25 million shares, when finally the negative stories go away, the sellers of their stock have completely sold out, and the stock starts to go up again.
Only...now things are a bit different. Instead of having $4 a share in cash, the company has $2 a share. They took 2 dollars a share, or 200 million bucks, to buy back their own stock, so a bit less cash...but it’s producing a dollar a year, and in 2 years it should have more than $4 a share again, just through cash that its normal operations produce. Way more importantly, the company has shrunk its capitalization from a market valuation of 800 million bucks. It was 8 dollars a share with 100 million shares outstanding, only now, the company has bought back 25 million shares, so it went from having 100 million shares outstanding to just 75 million now.
The new market value placed on the company at 8 bucks? Well, it’s $8 times 75 million, or $600 million. Cheap. Very cheap for a company expecting to have earnings of over 100 million dollars next year.
Note also what has dramatically changed here. In order to earn a dollar a share before the share repurchase, the company had to have 100 million bucks in earnings. Right? That’s 100 million in earnings divided by 100 million shares of stock to equal a dollar per share in earnings. But now, the company will still earn $100 million. The naysayers have all gone away, and now the company has 75 million shares outstanding...so on the same 100 million of earnings, they now earn 100 divided by 75...or $1.33 a share.
Note also that, when the company was at $25 a share before the shmeggeggie hit the fan, the equity value of the company was 21 times its earnings. That is, it was the 25 dollars a share minus the 4 dollars in cash to get 21, divided by the dollar a share in earnings. So that was 21 times the earnings for the equity value. But now, the company has bought back a fourth of its shares. Were it to return to that 21 times the equity value, that would be 21 times $1.33 to equal 28 bucks a share. It’s a lot easier to earn better than a dollar a share when they have only 75 million shares outstanding after this buyback...than it would have been with 100 million.
This is the dream scenario of share buybacks. Companies time the bottom in their own stock price, and when their price gets "stupidly cheap," they file a bunch of papers to crystal clearly disclose the details of the proposed buyback, and there ends up being a rosy shmegeggie at the end of the rainbow.
Related or Semi-related Video
Finance: What is a share buyback?1 Views
Finance allah shmoop what is a share buyback Investors put
a price on stocks every day every minute every second
they're willing to pay a certain price for that little
slice of pie of ownership in a company in that
price is re calculated all during the trading day Well
generally speaking over time those prices are there or at
least fair enough that is they're close enough to the
value that the company places on itself that the company
doesn't directly actively try to do anything about its share
price Structurally companies are of course always trying to you
know market themselves toe wall street but it's a rare
thing when companies actively hold up three fingers and tell
wall street Teo you know read between the lines when
companies flip the street the bird they're basically saying you
guys are idiots you don't get us our stock is
worth way more than what you're paying for it so
then cos basically put their money where their mouths or
ah you know fingers are sometimes both so then the
company begins the process of buying itself back from whatever
pieces are controlled are owned by wall street and or
the public that is The company goes into the open
market and starts buying back its stock one share at
a time Mcgee dot com makes gummy shaped candies in
weird semi erotic shapes A recent dental rating came out
which stated that shmoop gigi's were terrible for your teeth
and people should not eat them It came from that
darn fifth dentist who never recommends colgate toothpaste All right
well under this news fourteen of the six thousand stores
who sell shmoop gigi's pull the shmoop gigi's from their
shelves costing the company may be a penny a share
in earnings that quarter Like no big deal Instead of
earning a dollar and a penny this year well they'll
only earn a dollar big love big crisis in the
press though for like thirty seconds and then really no
big deal financially iii nobody cares That's mcgee's air bad
for you They are the chewy version of cigarettes and
kim kardashian right Well the stock however goes from trading
at twenty five dollars a share to just eight dollars
a share under a daily day luge of negative blog's
from school mothers who swear they'll never buy shmoop gigi's
again And what were they buying Semi erotic shape things
for their children anyway Like who are these mothers And
were they Really for the children All right well we
won't get into it The company has no debt and
it has four bucks a share in cash and no
big cap pecs needed like a new shmoop gigi smelting
machine factory on the horizon Will the company doesn't need
all the four dollars a share that they have and
think about that that's four dollars a share on an
eight dollars stock price Like a cat the stock prices
just cash It generates about a dollar a year in
cash cash flow So at the very least it decides
to immediately by back twenty percent of its shares outstanding
Happy to put toe work a few dollars a share
of cash on its books if you think about that
eight bucks a share Four bucks in cash and earns
a dollar means that the equity cap trading it four
times cash earnings like super cheap All right Well with
one hundred million shares outstanding they had four hundred million
dollars in cash and a market valuation of eight hundred
million bucks Will the company files a special form called
the ten b fiveone form which outlines how they will
buy back Every share they can up to two hundred
million dollars worth of stock for eight bucks a share
or cheaper like stock goes down from eight dollars They'll
buy more If goes up above eight dollars They'll just
stop knucklehead mothers and angry dennis continued to negatively blawg
about human g and a stock stays cheap but exactly
eight bucks a share or less So the company is
able to buy back two hundred million dollars worth of
stock that's two hundred million dollars divided by eight bucks
a share or twenty five million shares they've just bought
back When finally the negative stories go away the sellers
of their stock have completely sold out and the stock
starts to go up again on lee Now things were
a bit different instead of the company having four bucks
a share in cash while the company now has two
bucks a share in cash right they took two dollars
a share or two hundred million dollars to buy back
twenty five million shares of their own stock So now
they have a bit less cash but the company is
still producing a dollar a year in cash earnings and
in two years it should have more than four dollars
a share in cash again just through normal cash production
way More importantly the company has shrunk it's capitalization from
a market valuation of eight hundred million dollars Remembered how
one hundred million shares It was eight dollars times one
hundred Yeah only now the company has bought back twenty
five million share so it went from having one hundred
million out too Just seventy five million Will the new
market value placed on the company at eight bucks Well
it's eight times seventy five million or six hundred million
dollars cheap So at the moment they stop buying back
stock they had two hundred million dollars in cash or
two bucks a share in cash An equity valuation was
four hundred million dollars That were doing all the math
here for you Very cheap for a company expecting to
have earnings of over one hundred million dollars next year
Right It's still trading it four times on this number
Note Also what has dramatically changed here in orderto earn
a dollar a share Before the share repurchase the company
had to have one hundred million bucks and earnings right
One hundred Million dollars divided by one hundred million shares
of stock equal one dollars sharing earnings but now the
company will still earn that hundred million dollars The naysayers
have all gone away but now the company has only
seventy five million shares outstanding So on the same hundred
million dollars in earnings they now earn one hundred divided
by seventy five equals a dollar thirty three a share
instead of just a dollar Note also that when the
company was a twenty five bucks a share before bushman
gigi thing hit the fan the equity value of the
company was twenty one times its earnings That is it
was the twenty five dollars a share minus the four
dollars in cash to get twenty one divided by the
dollar a share in earnings there That was twenty one
times the earnings of the company in equity value but
now the company's bought back a fourth of its shares
Were it to return to that twenty one times earnings
for the equity value Well that would be twenty one
times that dollar thirty three Two equal twenty eight dollars
a share It's a lot easier to earn better than
a dollar A share when they have only seventy five
million shares outstanding after this By back then it would've
been with a hundred million And this is the dream
scenario of share buybacks Cos time the bottom in their
own stock price And when their price gets quote stupidly
cheap unquote they file a bunch Papers Teo give crystal
clarity and disclose the details of the proposed by back
And if they're lucky there ends up being a rosy 00:06:26.034 --> [endTime] shmoop g at the end of the rainbow