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.
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 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, 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 0.1% 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.
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 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 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.
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.