Step 1: Great Business/Stock Candidate - Practice 1 - Stock Repurchase

Jun. 13, 2015 2:48 PM ETIBM
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Contributor Since 2015

I am from IT industry and am interested in intelligent investing practices.

This is a very effective practice and seems it is not very well valued by the general market analysts. If a company has stable earning power and keeps repurchasing and retiring outstanding shares at a reasonable market price then the stock holders will be rewarded very well.

"If a company's growth rate for the whole business is very limited but can generate a lot of free cash, then the company's stock price is usually not very high because of the slow business growth. In this case the company can use the cash to buy back shares at the low price. If the buyback percentage is substantial then the benefit to the stock holders is huge. Some of the big oil companies use this strategy to reward their stock holders. One important condition here is the company's whole earning power should be stable and stay the same, or at least don't decrease too much for the long term."

Let's look at a simple, extreme example. Company X has very limited growth potential. Its business is stable and it has a price earnings ratio of 10 (P/E = 10) with total market capital of $100 million. It has 100 million outstanding shares and the stock price is $1. You are lucky enough and bought 1 share for $1.

The company has a very good return on equity and therefore only need to use 10% of its earnings to maintain its business operation. 90% of its earning is free cash for distribution. That means it has ($100 million / 10) * 90% = $9 million each year for distribution. If the company decides to channel the $9 million to its stock holders by repurchasing and retiring the outstanding shares each year, then after 11 years 99 million shares will be retired and there will be only 1 million outstanding shares, suppose its per-share price doesn't go up and remain $1 per share. On the 12th year, the company can use ($1 million) - ($1) to repurchase all the outstanding shares except for the 1 share you bought. You now have 1 share and own the whole company. If the company has the same earning power and same business scale then its value should remain the same ($100 million). That means you can turn $1 into $100 million in 12 years, an annual return rate of 316%.

In the real world you won't get that lucky because there are a lot of smart people on the market. What is going to be happening is the stock price goes up after the company repurchases more and more shares. The stock price going up has to be a sure thing and you will benefit from that if you don't sell your share.

Two key things here you have to remember for this practice to work. One is the repurchased shares should be retired and should not be for the purposes of stock awards or stock options for its employees. Otherwise the stock repurchasing won't benefit the stock holders. The other is the repurchasing price should not be too high. A company with good earing growth rate can also repurchase and retire shares. The reasonable repurchasing price should be estimated based on the expected earnings growth rate for the next 5 to 10 years.

Disclosure: The author is long IBM, AAPL, VRSN.

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