Accounting: Quick Fix

How will a buyback of shares provide a “quick fix” for EPS (earning per share)? A buyback allows companies to invest in themselves. By reducing the number of shares outstanding on the market, buybacks increase the proportion of shares a company owns. Buybacks can be carried out in two ways:

1. Shareholders may be presented with a tender offer whereby they have the option to submit (or tender) a portion or all of their shares within a certain time frame and at a premium to the current market price. This premium compensates investors for tendering their shares rather than holding on to them.

2. Companies buy back shares on the open market over an extended period of time. The typical advantage of a share buyback is that it increases earnings per share (EPS) since there are a fewer number of shares. The theory being that since EPS goes up, the stock price should as well. A buyback is also management’s way of telling the world that it believes that its stock is under-valued. It sends a signal that the company considers its shares undervalued, and it finds a use for some of that vast cash hoard many firms have. Companies could, of course, pay a dividend, but many prefer the flexibility of buybacks because they are occasional events (the issuance of a dividend usually creates an expectation of regular payouts) (Meyers, 2006).

1.A company that is buying back its own stock usually believes the stock is undervalued and believes it is a good buy. This is obviously a good sign for shareholders because the company is basically betting on their continued success. 2.Stock buybacks create a very nice price support level for investors. This is especially true in recessionary periods or bear market periods. A stock that has a massive stock repurchase program going on will have that extra price support that can serve as a safety net for investors in the stock. 3.Buying back stock means less outstanding shares, which means higher earnings per share number if all other things stay equal. A higher EPS number is always important in the market. Cons:

1 Serve as an easy cover up for poor financial ratios at the company. A company can buy their own shares and create an artificial lift in their
financial ratios which makes market observers believe things are improving, even if they are not. 2Allow the company insiders to take advantage of stock option programs while not diluting the overall EPS number that is reported to the market. Warren Buffett has noted on several occasions that he believes employee stock option programs and buyback programs can be quite shady. 3Typically creates a quick and often artificial jump in the price of a stock. Advantageous insiders then quickly sell at a higher price while individual investors tend to be late buying into the stock and buy in at high price levels.

Long-term prices haven’t been directly correlated to share repurchase announcements, but in the short-term stocks often bounce in a big way (Smith, 2009). 4Even though stock buybacks and share repurchases can be huge sources of long-term profit for investors, they are actually harmful if a company pays more for its stock than it is worth or uses money it cannot afford to spend. In an overpriced market, it would be foolish for management to purchase equity at all, even in itself. Instead, the company should put the money into assets that can be easily converted back into cash. This way, when the market moves the other way and is trading below its true value, shares of the company can be bought back up at a discount, giving shareholders maximum benefit (Kennon, 2007).

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A stock buyback for International Network Solutions will provide a quick fix for their earnings per share. In considering the financial position of the company, they are already in a strong position. The company has grown rapidly during the first ten years of operations and has excess funds from their European expansion. Normally a company that is mature and already has a strong financial position and a healthy dividend may well have good intentions for the company and the shareholder when buying back their own stock. A company with poor financial ratios and shady recent earnings results that announces a stock repurchase should be looked upon with much more trepidation. The next time you see a stock buyback announcement; take a close look at the company involved before making a final determination of what it may mean for the future of the stock. Is a share buyback ethical?

In this case, a stock buyback is ethical. International Network Solutions is considering a share buyback which is, in effect, an investment in the company’s own stock. They are purchasing stock because they expect to enhance shareholder value. In an era of abundant IPOs and stock placements, corporations also are announcing record buybacks of their outstanding shares. Repurchases serve a variety of purposes, from increasing earnings per share to providing stock for employee benefit plans. Although buybacks can be a sound part of a publicly held corporation’s financial strategy, they are complex endeavors that involve SEC rules, proper accounting and disclosure under GAAP, and certain federal income tax implications (CPA Journal, 2007). There are several cases when a share buyback is not ethical and it mainly deals with insider information. Below are examples of unethical share buybacks. A stock buyback will not be ethical if a company buys back its shares at the same time that executives are selling theirs. While there are no laws to prohibit officers and directors from selling company stock while the company is buying, investors and regulators are hypersensitive to even the appearance of conflicts of interest, some critics are asking whether officers and directors who promote and authorize massive stock-buyback programs should also be taking the other side of those trades (Meyers, 2006).

Stock buybacks would be unethical if executives benefited from stock buybacks through bonuses from meeting EPS targets. A stock buyback in this case would be potentially self-serving because many executives are compensated at least in part based on EPS targets, so using company money to inflate that figure can result in personal gain. Less clear is whether buybacks actually bump up the price of shares, allowing executives to garner more than they would have otherwise. In conclusion, a stock buyback is ethical unless the transaction violated Exchange Act Rule 10b-18. SEC rules governing stock buybacks include: (1) The issuer or affiliate must purchase all shares from a single broker or deal during a single day, (2) an issuer with an average trading volume less than $1 million per day, or a public float value below $150 million, is unable to trade within the last 30 minutes of trading and companies with higher average-trading-volume or public float value can trade up until the last 10 minutes, (3) the issuer must repurchase at a price that does not exceed the highest independent bid or the last transaction price quoted and (4) the issuer can’t purchase more than 25 percent of the average daily volume (Taub, 2008).

Sources Cited:

The CPA in Industry: Corporate Share Buybacks. (2007). The CPA Journal. Retrieved on Dec 12, 2009 from http://jobfunctions.bnet.com/abstract.aspx?docid=58545. Kennon, J. (2007). About.com. Retrieved on Dec 12, 2009 from http://beginnersinvest.about.com/od/incomestatementanalysis/a/share-repurchase-programs.htm#. Myers, R. (2006). Can you have your stock and sell it, too?. CFO Magazine. Retrieved on Dec 12, 2009 from http://www.cfo.com/article.cfm/8099425/c_2984290/?f=archives. Smith, A. (2009). Stock buybacks, the pros and cons examined. Stock Trading to Go. Retrieved on Dec 12, 2009 from http://www.stocktradingtogo.com/2009/05/22/stock-buybacks-share-repurchase-investing-pros-cons/. Taub, S. (2008). SEC extends buyback safe haven. CFO.com. Retrieved on Dec 12, 2009 from http://www.cfo.com/article.cfm/12366023/c_12339441.