When Companies Buy Back Their Shares

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More and more companies are buying back their own stock. In recent months, Caterpillar announced a $7.5 billion buyback, while Xerox said that it would purchase $500 million worth of its shares. Should you care? Perhaps. Stocks often climb after such announcements.

In a typical scenario, a company states that it will take cash from its corporate treasury and buy shares on the open market. This has the effect of reducing the total number of shares outstanding. Each remaining share then represents ownership of a bigger percentage of the company and its earnings.

Companies buy back shares for a variety of reasons. In some cases, the management thinks that the shares are cheap and make a good investment. Management could also use buybacks as a vehicle for propping up the stock. "When a company thinks the stock is undervalued, management may start buybacks and raise dividends," says Brian McMahon, chief investment officer of Thornburg Investment Management. "The idea is to persuade investors to bid up the shares."

Often the buybacks do boost shares. Companies with buybacks outperform the market averages, according to studies by David Ikenberry and Josef Lakonishok, professors at the University of Illinois. But the professors found that the biggest gains went to unloved value stocks. Even after big buybacks, high-priced growth stocks only matched the market. Stocks with modest prices and big buybacks currently include Citigroup, Microsoft, and Home Depot.

Keep in mind that announcements of buybacks can be misleading. Often companies announce a big repurchase plan—and then never follow through. In addition, some companies buy back shares at the same time that they are issuing new stock. In the end, the total number of shares stays the same. This kind of churning is often done by companies who must buy shares in the open market in order to reward employees with stock-option plans.

To make sure that a company is actually buying back stock, check the annual report or consult a Web site, such as Yahoo.com, which shows the number of shares outstanding. In a study, Ford Equity Research looked at companies that had reduced their shares by 5% in the past 12 months. These issues outperformed the market by a wide margin. By contrast, companies that increased their shares by 5% lagged the market.

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