If you’ve been investing for a while, you’ve probably heard about companies buying back their own shares. So what’s up with that? Why would companies engage in such behavior and perhaps more importantly, how does it influence your portfolio?
The answer is: To increase the profitability of existing shareholders.
Simple math: [bctt tweet=”More will be the shares, less will be the earning per share.” username=”sowmay_jain”]
Let’s imagine a situation.
Company XYZ has 1000 shares in all (500 with promoters and 500 with public)
Company earned 1000 Inr in any marvelous year.
EPS will be 1 per share.
Company decided to buyback 200 shares.
Now the EPS will be 1.25 (1000/800), assuming that the company earned 1000 Inr.
So earning increases by 25% per share by doing nothing extra with same earning. (just by reducing the quantity of the shares)
Isn’t it marvelous? That’s the only reason why MRF shares are so high. It have less outstanding shares in market. So that less holders are benefited more, which results in high price.
And also, if you’ve noticed, shares price always hiked after buy-back announcement. For example:
(I too invested in NMDC after hearing the announcement)
So it’s a good sign that company buyback it’s own share. So always be the early bird to enter in a stock before any announce of buy back of shares. It would be a great bet because of 2 reasons:
- Stock will hike immediately after the announcement.
- Stock is available at bargain rate, that’s why company managers decided to buy back their own stocks.
Generally companies buy back it’s own shares in 2 situation:
- Company’s stock are available at bargain rate.
- Company have huge cash reserve.
When this 2 conditions occur at same time, management of company decide to buyback it’s own shares.
But it sometimes also have some adverse effect. To buying back shares, company need huge cash reserve which may affect the operational activities regulated by cash and cash equivalent. For example: Iron ore miner NMDC fears cash shortage on share buyback plan – sources
Conclusion
Share repurchases are a great way for a company to create value for its shareholders, especially if the company has excess cash and little growth prospects, but only if they purchase their shares at a price below intrinsic value.
Action plan: always be a early bird to invest in such type of shares.