Stock Buybacks; Sustainable Smoke And Mirrors

My simplistic view of the stock market, the one my muddled brain is able to wrap around, is to imagine that of the waterfalls at the Continental Divide at Glacier National Park in Montana.  Numerous rivers, all converging into to one.  Hedge funds, pension funds, investment firms, your own 401k, option flows, you name it.........and share buybacks.

Throughout the recovery, the amount of cash being held on corporate balance sheets was in some instances, astounding, leaving many investors wondering if/when the cash would be deployed. 

Well if you haven't noticed, they have been deploying more and more.  Just imagine the many streams you see in this image to the right.  One is M&A which can be the acquisition of a company to compliment ones existing structure OR a direct competitor which is a plus for a stock by making your space that much smaller.  Another stream, a small one, is (hopefully) R&D, another stream represents cash being returned to shareholders via higher dividends and lastly we're seeing a great deal (large, wide stream) in the way of share repurchase programs.

You may ask "why repurchase shares when the markets at an all time high?"

Smoke and mirrors my friend.  Smoke and mirrors - especially when they're uncertain about near term sales and EPS growth.  Allow me to explain:

If a company has 10 million shares outstanding and earns $10 million per year, its earnings per share (EPS) is $1 ($10M/10M shares). If the stock has a price-to-earnings ratio (P/E) of 15, the stock will trade at $15 ($1 in EPS x 15 P/E).

When the company buys back 1 million of its shares, it still earns $10 million per year in profit, but now that $10 million is divided by 9 million shares instead of 10 million.

So although the company didn't earn any more money, earnings per share rises to $1.11 ($10M/9M shares). If the stock continues to trade at a P/E of 15, the stock climbs to $16.65.

Look at what just occurred. There was no change in the company's business, but through a reduced share count, earnings per share and the stock price jumped 11%.

Now this gives companies the ability to beat EPS because of the smaller float.  Nice trick, aye?

Now one alarm goes off in my head as I ponder this. 

Namely how long can buybacks be sustained?  What happens when the river begins to dry up? 

Well the hope would be that the economy, and overall demand, has recovered sufficiently to take over but what if it doesn't? 

What if global economies continue to be slow to heal.  Certainly rates are low, allowing companies to borrow on the cheap however is this trend sustainable?

Just food for thought my friends.......

(Click image to enlarge)

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