By JLP | June 27, 2007
This morning Best Buy announced that it will buy back as much as $5.5 billion of its stock. Share buybacks are not uncommon but are they a good deal for shareholders? It depends. If the company is really intent on reducing the number of shares of stock outstanding, then it can be a good deal. Why? Because if earnings stay the same but there’s less shares outstanding, it means earnings per share will be greater. To see what I mean, take a look at this very simple example:
So, based on this example, a 20% decrease in the number of shares outstanding increased the earnings per share by 25% even though the earnings as a whole didn’t change. Notice how if the stock price stays the same, the P/E ratio goes decreases to 16 from 20. However, if the P/E ratio were to remain at 20, the stock price would move to $25.00 ($1.25 × 20 = $25.00).
NOTE: Remember that the P/E ratio is Stock Price ÷ Earnings Per Share.
From this example, a buy back seems like a pretty good deal. However, it’s important to note that a buy back isn’t always the best use of the company’s money. For instance, what is the stock price is high? It doesn’t make sense to use company money to buy something that might be overvalued. Also, many investors might prefer dividends instead (Best Buy did announce they were increasing their quarterly dividend to $.13 from $.10). At the new dividend rate, Best Buy will yield a little over 1.10% based on today’s stock price. That’s a pretty stingy dividend yield in my opinion.
In a lot of cases, I think it is a control issue. When a company pays a divdend, those dollars are gone. A buy back is different because companies might allocate money for a buy back but there’s no guarantee they’ll actually follow through. As a shareholder, I think I would prefer a dividend payment.
I have just touched on the very basics here. For more on stock buy backs, see this article on Investopedia.