If stock splits and buybacks have been a bit of a mystery to you, you're not alone. While the number of companies initiating stock splits and buybacks ebbs and flows as market conditions change, most long-term 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 before they find themselves having to make an investment decision regarding one of these scenarios. In this article, we'll review buybacks, stock splits, and reverse stock splits, taking a close look at when each might be a good or bad deal for investors.

Key Takeaways

  • A stock buyback is when a publicly traded company repurchases its own stock and either cancels the shares or turns them into treasury shares.
  • Because a buyback reduces the number of shares available to trade in the market, the value of each existing share increases.
  • A company's management may initiate a buyback if they believe the stock is significantly undervalued and as a way to increase shareholder value.
  • While a stock split doesn't immediately increase shareholder value, investors can see it as a bullish sign for the company that could over time mean a rise in the stock price.

Stock Buybacks

A stock 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 it repurchases shares, those shares 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, investors should review the company's motives for initiating the buyback. If the company's management did it because they felt their stock was significantly undervalued, this is seen as a way to increase shareholder value, which is a positive signal 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.

Examples of a Stock Buyback

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.

Between fiscal years 2017 and 2019, Microsoft (MSFT) bought back about 419 million shares for a total repurchase of $35.7 billion. In the quarter ending June 2019, the tech giant purchased $4.6 billion or about 3.8% of its own stock. Microsoft has a history of engaging in stock buybacks. In 2013 and again in 2016, the company's board of directors authorized $40 billion to repurchase stock.

How to Make Money on a Buyback

What's the best way to make money on a repurchase? Invest in companies with a strong balance sheet. This makes 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. However, in the case of a growing and profitable company, a share buyback often happens as a result of strong fundamentals.

Critics of stock buybacks say the action emphasizes the short-term enrichment of shareholders at the expense of investing in the business itself, something that could negatively impact the company's growth over the long term.

Stock Splits

If you had a $10 bill and somebody offered to give you two $5 dollar bills in exchange, 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 money immediately, but they shouldn't sell the stock since the split is likely a positive sign.

Reverse Splits

A reverse split works the opposite way of a split. 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 that do this.

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

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. Look beyond what the company is saying is the reason for their actions and review how it might impact their financial statements going forward.