If stock splits and buybacks have been a bit of a mystery to you, you're not alone. Although they haven't been as popular in the past couple of years, most 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.

Stock Buyback
A 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 the shares are repurchased, they are either canceled or made in to treasury shares. Either way, this lowers the amount of shares in circulation, which increases the value of each share, at least temporarily.

In order to profit on a buyback, the motives have to be right. If they did it because they felt their stock was significantly undervalued, this is seen as a way to increase shareholder value, a positive 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.

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 .1% of their maximum price on the day the repurchase was announced.

What's the best way to make money on a repurchase? Invest in companies with a strong balance sheet making 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, but in this case, share buybacks often happen as a result of strong fundamentals.

Splits
If you had a $10 bill and somebody offered to give you two $5 dollar bills, 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 in to 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 2-1 but it'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 immediate money, but they shouldn't sell the stock since the split is likely a positive.

A reverse split works the opposite way. 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 who do this.

Remember that splits may be a reason to buy and reverse splits may be a reason to sell.

VIDEO: Understanding Stock Splits

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.

Related Articles
  1. Mutual Funds & ETFs

    Comparing ETFs Vs. Mutual Funds For Tax Efficiency

    Explore a comparison of mutual funds and exchange-traded funds, or ETFs, and learn what makes ETFs a significantly more tax-efficient investment.
  2. Mutual Funds & ETFs

    4 Mutual Funds that Hold Tesla Stock

    Obtain information on the four mutual funds that have significant allocations to Tesla Motors, Inc. in their major portfolio holdings.
  3. Mutual Funds & ETFs

    4 Mutual Funds that Hold Apple Stock

    Discover mutual funds offering the most substantial percentage of holdings in Apple, Inc. stock that investors can use to get significant exposure to Apple.
  4. Mutual Funds & ETFs

    ETF Analysis: Vanguard Small-Cap Value

    Find out about the Vanguard Small-Cap Value ETF, and explore detailed analysis of its characteristics, suitability, recommendations and historical statistics.
  5. Mutual Funds & ETFs

    Top 3 Switzerland ETFs

    Explore detailed analysis and information of the top three Swiss exchange-traded funds that offer exposure to the Swiss equities market.
  6. Mutual Funds & ETFs

    Top 5 Chinese Mutual Funds

    Learn about some of the most popular and best performing mutual funds that offer investors exposure to the important emerging market economy of China.
  7. Investing Basics

    Explaining Unrealized Gain

    An unrealized gain occurs when the current price of a security exceeds the price an investor paid for the security.
  8. Investing Basics

    Explaining Risk-Adjusted Return

    Risk-adjusted return is a measurement of risk for an investment or portfolio.
  9. Investing

    What’s Holding Back the U.S. Consumer

    Even as job growth has surged and gasoline prices have plunged, U.S. consumers are proving slow to respond and repair their overextended balance sheets.
  10. Credit & Loans

    What's a Nonperforming Loan?

    A nonperforming loan is any borrowed sum where the borrower has failed to pay scheduled payments for at least 90 days.
RELATED TERMS
  1. Gross Profit

    A company's total revenue (equivalent to total sales) minus the ...
  2. Receivables Turnover Ratio

    An accounting measure used to quantify a firm's effectiveness ...
  3. International Financial Reporting ...

    A set of international accounting standards stating how particular ...
  4. Balance Sheet

    A financial statement that summarizes a company's assets, liabilities ...
  5. Equity

    The value of an asset less the value of all liabilities on that ...
  6. Exchange-Traded Fund (ETF)

    A security that tracks an index, a commodity or a basket of assets ...
RELATED FAQS
  1. What is the formula for calculating compound annual growth rate (CAGR) in Excel?

    The compound annual growth rate, or CAGR for short, measures the return on an investment over a certain period of time. Below ... Read Full Answer >>
  2. What are some examples of general and administrative expenses?

    In accounting, general and administrative expenses represent the necessary costs to maintain a company's daily operations ... Read Full Answer >>
  3. What is the difference between called-up share capital and paid-up share capital?

    The difference between called-up share capital and paid-up share capital is investors have already paid in full for paid-up ... Read Full Answer >>
  4. Why can additional paid in capital never have a negative balance?

    The additional paid-in capital figure on a company's balance sheet can never be negative because companies do not pay investors ... Read Full Answer >>
  5. When does the fixed charge coverage ratio suggest that a company should stop borrowing ...

    Since the fixed charge coverage ratio indicates the number of times a company is capable of making its fixed charge payments ... Read Full Answer >>
  6. What does a high turnover ratio signify for an investment fund?

    If an investment fund has a high turnover ratio, it indicates it replaces most or all of its holdings over a one-year period. ... Read Full Answer >>

You May Also Like

Trading Center
×

You are using adblocking software

Want access to all of Investopedia? Add us to your “whitelist”
so you'll never miss a feature!