What Are the Stock Buyback Benefits for Investors?

Stock buybacks have surged in popularity over the last 10 years, and retail investors can reap a number of stock buyback benefits. But it's important to understand how buybacks work before determining if they're good for your portfolio.

Here's everything you need to know about stock buybacks...

How Does a Stock Buyback Work?

A stock buyback is when a company literally buys back shares from shareholders. A stock buyback reduces the number of shares outstanding.

Because the company is publicly owned and traded, it repurchases the stock so it can have better control over voting rights.

There are two types of buybacks: tender offer and open market.

A tender-offer buyback is when a company makes a deal to buy shareholders' shares. If the shareholders accept, they negotiate the number of shares they'll give - or "tender" - and the price. This type of stock buyback benefits investors because the company always buys the shares at a premium to the current stock price.

stock-buybacks-graphicThe second and simpler type is an open-market buyback. That's when a company acts like any other individual investor. It buys shares on the stock market at the market price. Open-market buybacks are large-scale yet more efficient because they don't involve bartering with shareholders over the price.

Both types of stock buybacks have surged in popularity recently. The Academic-Industry Research Network reported more than $6.9 trillion has gone into stock buybacks since 2004.

Last month, Wal-Mart Stores Inc. (NYSE: WMT) and Hewlett-Packard Co. (NYSE: HPQ) announced $20 billion and $3 billion buyback programs, respectively.

But the excess number of buybacks is becoming a problem. Many large corporations are issuing buybacks to cover up their financial troubles.

"I'm not all that sure that they aren't way out of control," said Money Morning Capital Wave Strategist Shah Gilani. "Buybacks are the biggest part of what we now call financial engineering."

Money Morning Capital Wave Strategist Shah Gilani reveals more about the often insidious nature of stock buybacks. Then he explains how investors can play buybacks to turn a profit...

 

Wal-Mart is the perfect example of financial engineering. On Oct. 14, WMT stock plunged 10% after the retail giant slashed its sales forecast for 2015. After shedding $20 billion in market value that day, Wal-Mart tried to soften the blow by announcing its buyback program.

While some stock buybacks are just financial engineering tactics, you can still bank profits from them if you make the right moves.

Here's how a stock buyback benefits retail investors like you and me...

The Biggest Stock Buyback Benefits for Investors

The most common stock buyback benefits are boosts in stock price and earnings per share (EPS). When a company repurchases shares, it lowers the number of outstanding shares and raises the stock price due to simple market dynamics. The reduced share count also boosts EPS by giving investors a slightly bigger slice of the company's profit.

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While all buybacks offer these perks, Money Morning Chief Investment Strategist Keith Fitz-Gerald says investors should avoid large open-market buybacks. That's because they affect a company's productive capacity.

You see, productive capacity is the highest level of output a company can maintain using current resources. The most obvious resource for high-volume production is working capital - a company's excess cash after it pays debts and liabilities.

Open-market buybacks reduce productive capacity because they eat into a company's working capital. That's never good for business since working capital is used to make the profitable good or service. Since they eat into profits, open-market buybacks hurt the company and its stock over the long term.

Tender-offer buybacks are better because they involve owned shares rather than outstanding shares. They're also performed on a small scale, allowing the company to keep more profit despite paying a premium for the shares.

"Open-market buybacks work against the shareholder by affecting productive capacity," Fitz-Gerald said. "The advantage of tender offers is companies can make them without interrupting cash flow."

The Bottom Line: Many investors wonder how a stock buyback benefits their portfolio. Although they're surging in popularity and theoretically boost earnings per share, don't be fooled by the companies using them to cover losses. Make sure to target tender-offer buybacks instead of open-market buybacks for the best long-term gains.

Alex McGuire is an associate editor for Money Morning. Follow him on Twitter at @AlexMcGuire92.

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