If stock splits and buybacks have been a bit of a mystery to you, you're not alone. While the number of companies initiating stock splits and buybacks ebbs and flows as market conditions change, most long-term investors have been affected by at least one of these events in the past. And if they haven't, it probably won't be long before they find themselves having to make an investment decision regarding one of these scenarios. In this article, we'll review buybacks, stock splits, and reverse stock splits, taking a close look at when each might be a good or bad deal for investors.
Key Takeaways
- A stock buyback is when a publicly traded company repurchases its own stock and either cancels the shares or turns them into treasury shares.
- Because a buyback reduces the number of shares available to trade in the market, the value of each existing share increases.
- A company's management may initiate a buyback if they believe the stock is significantly undervalued and as a way to increase shareholder value.
- While a stock split doesn't immediately increase shareholder value, investors can see it as a bullish sign for the company that could over time mean a rise in the stock price.
Stock Buybacks
A stock buyback takes place when a company uses its cash to repurchase stock from the market. A company cannot be a shareholder in itself so when it repurchases shares, those shares are either canceled or made into treasury shares. Either way, this lowers the number of shares in circulation, which increases the value of each share—at least temporarily.
In order to profit on a buyback, investors should review the company's motives for initiating the buyback. If the company's management did it because they felt their stock was significantly undervalued, this is seen as a way to increase shareholder value, which is a positive signal for existing shareholders. If they repurchased the shares because they want to make certain metrics look better when nothing material has changed, investors may see this as a negative causing the stock to sell-off.
Examples of a Stock Buyback
In September 2011, Berkshire Hathaway announced a share buyback where they actually disclosed the maximum amount they were willing to pay for the shares. Although the purchase price isn't normally disclosed, Berkshire increased the value of the stock for investors as the stock came within 0.1% of their maximum price on the day the repurchase was announced.
Between fiscal years 2017 and 2019, Microsoft (MSFT) bought back about 419 million shares for a total repurchase of $35.7 billion. In the quarter ending June 2019, the tech giant purchased $4.6 billion or about 3.8% of its own stock. Microsoft has a history of engaging in stock buybacks. In 2013 and again in 2016, the company's board of directors authorized $40 billion to repurchase stock.
How to Make Money on a Buyback
What's the best way to make money on a repurchase? Invest in companies with a strong balance sheet. This makes a share repurchase a positive action in the eyes of investors. As with any investing strategy, never invest in a company with the hopes that a certain event will take place. However, in the case of a growing and profitable company, a share buyback often happens as a result of strong fundamentals.
Critics of stock buybacks say the action emphasizes the short-term enrichment of shareholders at the expense of investing in the business itself, something that could negatively impact the company's growth over the long term.
Stock Splits
If you had a $10 bill and somebody offered to give you two $5 dollar bills in exchange, would you feel a little richer? A stock split doesn't add any value to a stock. Instead, it takes one share of a stock and splits it into two shares, reducing its value by half. Current shareholders will hold twice the shares at half the value for each, but the total value doesn't change. The ratio doesn't have to be 2 to 1, but that's one of the most common splits. The ratio is often dependent on the price. Higher priced stocks may split enough times to get the share price below $100.
Splits are often a bullish sign since valuations get so high that the stock may be out of reach for smaller investors trying to stay diversified. Investors who own a stock that splits may not make a lot of money immediately, but they shouldn't sell the stock since the split is likely a positive sign.
Reverse Splits
A reverse split works the opposite way of a split. Those two $5 bills would become one $10 bill. Reverse splits should be met with skepticism. When a stock's price gets so low that the company doesn't want it to look like a penny stock, they sometimes institute a reverse split. History has shown less than stellar results for companies that do this.
Remember that splits may be a reason to buy shares in a company and reverse splits may be a reason to sell shares.
What is a Stock Buy Back?
A stock buy back is when a corporation purchases its own shares, thereby reducing the number of shares available for purchase on the open market.
What is a Stock Split?
A stock split is when a company increases the number of its outstanding shares by dividing one share into two or more shares.
What is a Reverse Share Split?
A reverse share split is as its name suggests the opposite of a share split. The corporation combines two or more shares into one and effectively reduces the number of shares outstanding
The Bottom Line
Splits and buybacks may not pack the same punch as a company that gets bought out, but they do give the investor a metric to gauge the management's sentiment of their company. One thing is for sure: when these actions take place, it's time to reexamine the balance sheet. Look beyond what the company is saying is the reason for their actions and review how it might impact their financial statements going forward.
FAQs
In order to profit on a buyback, investors should review the company's motives for initiating the buyback. If the company's management did it because they felt their stock was significantly undervalued, this is seen as a way to increase shareholder value, which is a positive signal for existing shareholders.
How to profit from stock buybacks? ›
The share buyback price is pre-decided by the company. For every share tendered, investors benefit. In the open market option the company buys back shares from the open market over an extended period. In the tender offer, investors receive the benefit, as they can sell their shares at a higher price.
How do you profit from a reverse stock split? ›
If you own 50 shares of a company valued at $10 per share, your investment is worth $500. In a 1-for-5 reverse stock split, you would instead own 10 shares (divide the number of your shares by five) and the share price would increase to $50 per share (multiply the share price by five).
Is share buyback profitable? ›
Share buybacks enable companies to raise shareholder value. Under normal market conditions, the portion of profits a company uses to buy back shares should strengthen its share price.
Is it better to buy before or after a stock split? ›
If a company was a bad investment before a stock split, it would still be a bad investment. If it were a good investment before the split, it would still be a good investment, and now may be more affordable to some investors due to the reduced share price.
Who benefits most from stock buybacks? ›
Share buybacks can create value for investors in a few ways: Repurchases return cash to shareholders who want to exit the investment. With a buyback, the company can increase earnings per share, all else equal. The same earnings pie cut into fewer slices is worth a greater share of the earnings.
Should I sell after a reverse split? ›
Selling before a reverse stock split is a good idea, but selling after the reverse stock split is not. Since you can sell before and after a reverse stock split, selling during one is optional. The main advantage of selling before the reverse stock split is that you don't have to wait around for it to happen.
Do investors make money on a reverse stock split? ›
As previously noted, the reverse split itself doesn't result in any change in the value of an investor's position in a stock because the smaller number of post-split shares is offset by the proportionally higher per-share price. However, a reverse split can certainly change investor perception of the company.
Can you lose stock in a reverse split? ›
The reverse stock split doesn't cause investors to lose money by itself, but the move can signal to investors that the company is in financial trouble, which can lead to a sell-off. This will lower the value of the stock price, and stockholders will lose money.
What is a 1 to 4 reverse stock split? ›
For example, a 1-to-4 (or 1:4) reverse stock split means that a person with 4 shares now has 1, and each of those shares are now worth 4 times the previous value. In a 1-to-3 reverse stock split, a person with 3 shares now has 1 share. Subsequently, each of those shares is now worth 3 times the previous value.
A buyback will increase share prices: Stocks trade in part based on supply and demand, and a reduction in the number of outstanding shares often precipitates a price increase.
What are the disadvantages of share buybacks? ›
Disadvantages. A criticism of buybacks is that they are often ill-timed. A company will buy back shares when it has plenty of cash or during a period of financial health for the company and the stock market. The stock price of a company is likely to be high at such times, and the price might drop after a buyback.
Why were stock buybacks illegal? ›
For most of the 20th century, stock buybacks were deemed illegal because they were thought to be a form of stock market manipulation.
Do stocks usually go up after a split? ›
A stock split can make the shares seem more affordable, even though the underlying value of the company has not changed. It can also increase the stock's liquidity. When a stock splits, it can also result in a share price increase—even though there may be a decrease immediately after the stock split.
What do stocks typically do after a split? ›
Normally, a stock split will reduce the price per share of each share in proportion to the increase in shares. Using this example, a 2-1 split for a stock trading at $200 would halve the price to $100 and double the number of total shares outstanding.
Do stocks do well after a split? ›
Splitting the stock brings the share price down to a more attractive level. The actual value of the company doesn't change but the lower stock price may affect the way the stock is perceived and this can entice new investors.
How to take profits from stocks without selling? ›
How To Make Money In Stock Market Without Selling Your Shares?
- Using the demat value of the shares as margin for trading. ...
- Getting a loan against your shares (LAS) ...
- Creating cash-futures arbitrage to earn the spread. ...
- Sell higher options to keep reducing your cost of holding the stock. ...
- Consider stock lending of these shares.
The required shares must be in the demat account before the offer ends. Do not sell shares after placing the order. Buyback orders cannot be modified. However, the client can delete or cancel the existing order and place a new one.
What happens if a company buys back all of its stock? ›
The correct answer is that a buyback of all shares is a liquidation. If there are zero shares, this can only mean the company no longer exists. Note that in normal (partial) buybacks, the company shrinks in value. The natural extreme of this is that the company disappears.
How is buybacks better than dividends? ›
Buybacks are clearly a more tax-efficient way to return capital to shareholders because the investor doesn't incur any additional tax on the buyback sale process.
