Article written by Sherin Dev. Follow me on Twitter
Here I am cracking a hidden wealth secret, how share buyback by companies turning investors wealthy and add value to their investments. Here is the same what Warren Buffett found and using to add wealth to his investments.
After reading this article, you will get all the required knowledge about how a company helps to add value to investors money by consistent share buybacks.
To make sure you have better understanding, I will start with a very simple but solid example:
Suppose, company XYZ issued 1 lakh shares for $10 each to collect one million dollars ($10 lakh). This means that each share now have a value of $10 ($1000000 / 100000 number of shares).After running their business successfully, company now deciding to buy back 50000 shares back from it’s originally issued 1 lakh shares. After buying back, only 50000 shares now available with investors in the open market.Calculate the value of each share now. Previously it was $10 per share but now, after buying back half of the previously issued shares, its value now increasing from present $10 per share to $20 per share. It is calculating by total shareholders equity divided by outstanding shares. In our case it is 1000000 / 50000. The result of this of course, $20 per share.
Certainly there is a possible question I can expect. After buying half of its shares back, how can we still use the shareholders equity as 10 lakhs? It should be 5 lakhs rights?
Good question. But, as I mentioned earlier, company now using its profit to purchase the shares and not at all touching the previously collected shareholders equity of 10 lakhs. It is still with them as working capital. Thus the shareholders equity is still 10 lakhs but the outstanding shares are only 50000 compare with previously issued 1 lakh. Certainly it add additional $10 to each shares and thus the value of each outstanding share is no $20.Hope, you have understood the way, how share buyback adding value to your invested capital.
You have some basic points to remember here. In the above example, I have mentioned how share buybacks adding value to existing shares. It doesn’t mean that a company required to purchase half of its outstanding share by one shot. Companies, generally using their excess money to buy back its outstanding shares gradually and time to time. A consistent buyback in each year, is a good signal.
You can have the information on share buy back from the Cash Flow statement, under Cash Flow from Financing (CFF) activity.
An important point to keep in mind is, when analyzing a company to know its history of buying back shares, always remember to analyze any possible new share issues at the same time. It is possible that companies buying back some number of shares but issues huge number of new shares at the same time. If such, investors value will not changed but, it may shrink due to such new issuance.
Image courtesy: AMagill