JNJ and COP announce Stock buyback? So what?

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Yesterday JNJ and COP announced stock buyback program for US$10 billions and US$15 billions respectively. Should you care?

When a company announces a stock buyback or repurchase, it’s time to take a close look at what’s behind the action. This step can be good news for shareholders or just a smokescreen to cover some pitiful financial ratios.

What is stock buybacks:

The Company wants to purchase outstanding shares of its stock, that is shares held by the public outside of its control. It can do this one of two ways:

  • It can tender an offer to existing stockholders to buy up to a certain number of shares at a fixed price (usually at a premium over the current market price). There is a time limit on the offer.
  • The other way is to buy the shares in the open market over a fixed period.

So why should you care?

But let’s spend a minute to think why would a company want to buy back its own shares? Ideally it is done to increase shareholder’s value. Let’s review:

  1. If a company is sitting on a large sum of cash, it must decide how to invest it. One of the options is to distribute part of it to shareholders. Companies can do this either of two ways: as dividends or buy buying up outstanding shares.
  2. If a company’s stock is suffering from low financial ratios, buying back stock can give some of the ratios a temporary boost. Key ratios like earnings per share and price earnings ratio look better because they are based on the number of outstanding shares. Reduce the number of shares and even though earnings don’t change, the EPS looks better.
  3. Another reason companies buy back stock is to cover large employee stock option programs. Buying back shares reduces dilution and increases shareholder value.
  4. Some companies buy back shares as protection against unfriendly takeovers from other companies. By gathering outstanding shares off the open market, the company makes it more difficult for a competitor to take control.

But why should you care?

Because you may be able to improve returns on your investing dollars by focusing on firms that are buying back their own shares assuming that your companies are actually doing it rather than just talking about it. Do take a note though, these companies are not legally bound to actually make the announced purchases. Firms may purchase fewer shares than originally announced or they sometimes may cancel the entire transaction.

But how do you find if a company is following through on its buyback announcement?

Head over to balance sheet: checking the “total common shares outstanding” figure listed near the bottom of its quarterly balance sheet. A share buyback should be reflected in fewer shares outstanding in the quarters following the buyback announcement.

A brief case study: Microsoft

msft-buyback-case-study.pngSince Jul 20, 2006 announcement of Microsoft’s plans to buyback $40billion worth of shares from the market, it has already reduced 490million shares outstanding. As of June 30, 2006 balance sheet, outstanding shares were 10,062 millions but as of Mar-07 quarterly report, outstanding shares are now 9,572 millions check here. This buyback was done in two stages, $20billion in tender from $22.5 to $24.75 (MSFT was at $22.85 then) and remaining $20billion worth of shares via traditional methods through 2011. Since then MSFT has been doing pretty good. Now one may argue that during the same time market was on bull run, right it was, but here is the comparison chart. And you will notice that MSFT has outperformed Nasdaq by 3%, Dow by 6%, and S&P500 by 9%. The outformance is even more if we disregard Jun/Jul period, but that’s not an excuse.

Net, if the announcement is followed through smartly, there are ways to make money simply by following this strategy. I have not studied other tickers due to lack of time. If you do, pls do let me know and I shall publish it here. You’ll do best by focusing on stocks that actually follow through and buy back significant shares, as shown by the balance sheets’ shares outstanding figures, as opposed to those that have simply announced a buyback.

There are a lot of buyback announcements, but which ones to follow? I shall share with future OPN subscribers on which stocks to select and how to apply this strategy in option trading, to generate more returns than simple out performance.

I am also adding a new site in OP’s toolbox to find recent buyback announcement on Look for it in the Calendars’ section of the site index.

Profitable investing, OptionPundit


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2 responses to “JNJ and COP announce Stock buyback? So what?”

  1. gricey Avatar

    Hi OP,

    There was one criteria I think you missed. Companies, that are obliged to their shareholders, have to review the purchase of their own shares in this light. i.e. they have to believe that their own stocks represents a sound investment that will return profits for their shareholder. The sort of considerations they would balance include, are there any other take-over targets that may achieve similar returns, or are their investments in other companies (non-controlling ownership) that represent better value.

    Thus, companies buying up their own stock must believe there is value in it as a stand alone investment (the other benefits aside) and hence why it makes these stocks attractive to investors.

    Just my 2 cents worth!

    Regards, Dave.

  2. OptionPundit Avatar

    Dave, thanks for an excellent point.
    This is surely a case as “management” is answerable to its investors on the money beging invested.

    Regards, OP

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