In a perfect world, financial decisions would be based solely on numbers. Unfortunately, that’s not the case in the real world. Investor confidence is influenced by public perception and, inevitably, in order to understand where the stock market might be moving, it is important to understand what the public might be thinking.
The true value of any given stock, after all, is whatever investors are willing to pay for it.
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Share buybacks are a good example of how public perception and stock price can have a complicated relationship. When done under the right circumstances, stock buybacks can be viewed as a savvy business move to boost shareholder earnings. However, if the buyback appears to be an act of desperation, the ensuing result could be just the opposite.
Some companies can weather the storm. Large-cap companies can absorb the hit. Their stock price can drop and recover, as we have seen occur over many boom-and-bust economic cycles.
On the other hand, small- and mid-cap businesses have a smaller margin for error. Due to their relatively limited size, small companies cannot afford to lose the trust of the public for very long. This creates a situation in which share buybacks are typically avoided.
Sacrificing Liquidity to Increase Dividends with Share Buybacks
Liquidity will directly affect how easily a business can use its capital to actually pay for things. When cash is converted into stocks—something that buybacks necessitate—capital becomes less liquid. Using that cash means sacrificing short-term liquidity to increase dividend payouts to the remaining shareholders. It appears to be a solid business decision, but market insiders may question the motives behind it.
Liquidity ratios are one of the variables that serious investors look at when evaluating stock purchases. A ratio of 2:1 is preferred because it shows the company can easily pay its bills in a timely fashion. Anything less than that can indicate debt management issues. Of course, this will vary by company, but liquidity is something all CFOs and key decision-makers need to actively think about.
The company can, of course, re-sell shares to raise cash if they get in trouble. But this is something most companies will want to avoid. Unfortunately, reaching that point usually means that the share buyback didn’t work as planned. The value of those shares will be lower, and the business will end up taking a loss—this defeats the entire purpose of doing a buyback, to begin with.
Share Buybacks to Boost Management Earnings
Many managers receive stock options as a part of their compensation, which creates an incentive to put the stock price “in the money” at a specific point in time. Management stock options are worthless if the stock price doesn’t hit a certain point. Share buybacks reduce the number of shares on the market and usually result in the price increase that executives need to exercise their options. This is common knowledge for investors.
Once again, it is important to think about public perception. As a whole, investors want to know what is going on. If these investors see any red flags or suspicious behavior, they are much more likely to want to sell. Share buybacks that are done solely for management earnings suggest a lack of confidence in the sustainability of the company. Outside investors see that and may choose to sell their shares and look elsewhere, triggering a downtrend.
Another possibility in this scenario is that a merger or acquisition is about to happen. In some cases, a merger or acquisition will appeal to investors, in others, it won’t. Upper-level management will often trigger their stock options when either is in the works. If that’s the motive behind the buyback, it might be a good idea to make this known to the public.
Evaluating Equity Share Percentages
Stock ownership often comes with certain perks, like voting rights and dividends, and nobody knows this better than the company itself. Another motive for share buybacks is to increase the equity share percentage controlled by ownership. This can be a market indicator also, so the statement of intent must be clearly defined in the buyback offer. It’s not a good idea to let investors form their own opinions.
The more a company can do to explain why it is taking certain actions, the more confident the company’s investors can be.
The target ownership percentage should be directly tied to the available cash flow and liquidity ratio. Using too much cash suggests an acquisition is in the works. Using too little makes the buyback seem like a management ploy to increase their own profits. There needs to be a balance.
Ownership typically controls 51% or more of a company’s total equity shares. This makes it possible to vote however they want and “win.” When increasing that number through a buyback, the most sensible way to do it is to keep the target percentage in single digits. Buying back 5% will raise fewer eyebrows than targeting 10%.
Debt Reduction Before the Share Buyback Offer
As we all know, many can only be used to pay for one thing at a time. If a dollar is used for a stock buyback, that same dollar cannot be used for paying down debt or improving the business’ operations. Think about this from a commonsense perspective. Using cash on hand for a share buyback without paying off outstanding debt can be viewed as irresponsible. Investors have mortgages, car payments, and college tuition bills. They understand the impact of debt.
Eliminate some debt before putting the buyback offer out there. This shows that the company is being responsible and will temper insider criticism, especially for small- or micro-cap firms, which are always under fire. Paying off debt shows executive maturity.
It’s not necessary to zero out all accounts payables. Almost all companies will have at least some type of debt. Go back to that liquidity ratio and use it as a guideline. After the debt is paid, how much cash is left? Recalculate liquidity and then set the equity share percentage target. Relying on the math can help control investor perception.
Investor Perspective: Ploy or Good Play?
To understand whether a stock buyback is a good move or a bad move, you need to first understand the underlying motive.
The primary motive behind any share buyback is to increase the stock price, so holding instead of selling in this scenario is probably the right move. That is, of course, based on the offer price. If it’s high enough for you to see a substantial gain, take it.
An article in the Harvard Business Review last year presented an argument against share buybacks, claiming that they are “dangerous for the economy.” Their reasoning is that major corporations are using them as “debt-funded payouts.” That classifies as a ploy.
With small- and micro-cap companies, it is possible that they are also doing debt-funded payouts, but it’s more likely that they’re simply trying to increase their stock price to boost investor confidence. That makes it a good play.
Should you invest in a company that has a history of share buybacks? Do some research. Are their dividend payouts higher? Are the liquidity and debt-to-income ratios in line with industry standards? If the answers are positive, take a shot. If not, don’t.
Article by Investor Summit Group