The Benefits of Stock Buy Back Programs
The Golden Egg of Shareholder Value
All investors have no doubt heard of corporations
authorizing share buy back programs. Even if you don't know what
they are or how they work, you at least understand that they are
a good thing (in most situations). Here are three important
truths about these programs - and most importantly, how they
make your portfolio grow.
Principle 1: Overall growth is not nearly as
important as growth per share
Too often, you'll hear leading financial
publications and broadcast talking about the overall growth rate
of a company. While this number is very important in the long
run, it is not the all-important factor in deciding how fast
your equity in the company will grow. Growth per share is.
An over-simplified example may help. Let's
look at a fictional company:
Eggshell Candies, Inc.
$50 per share
100,000 shares outstanding
Market Capitalization: $5,000,000
This year, the company made a profit of $1
In this example, each share equals .001% of ownership in the
Management is upset by the company's
performance because it sold the exact same amount of candy this
year as it did last year. That means the growth rate is 0%! The
executives want to do something to make the shareholders money
because of the disappointing performance this year, so one of
them suggests a stock buyback program. The others immediately
agree; the company will use the $1 million profit it made this
year to buy stock in itself.
So the very next day, the CEO goes and takes
the $1 million dollars out of the bank and buys 20,000 shares of
stock in his company. (Remember it is trading at $50 a share
according to the information above.) Immediately, he takes the
shares to the Board of Directors, and they vote to destroy them
so that they no longer exist. This means that now there are only
80,000 shares of Eggshell Candies in existence instead of the
What does that mean to you? Each share you own
no longer represents .001% of the company. Instead, it
represents .00125%; that's a 25% increase in value per share!
The next day you wake up and find out that your stock in
Eggshell is now worth $62.50 per share instead of $50. Even
though the company didn't grow this year, you still made a
twenty five percent increase on your investment! This leads to
the second principle.
Principle 2: When a company reduces the
amount of shares outstanding by declaring a stock buy back
program, each of your shares becomes more valuable and
represents a greater percentage of equity in the company.
If a shareholder-friendly management such as this
one is kept in place, it is possible that someday there may only
be five shares of the company, each worth one million dollars.
When putting together your portfolio, you should seek out
businesses that engage in these sorts of pro-shareholder
practices and hold on to them as long as the fundamentals remain
sound. One of the best examples is the Washington Post, which
was at one time only $5 to $10 a share. It has traded as high as
$650 in recent months. That is long term value!