Login | December 26, 2024
Stock buybacks explained
THE MOTLEY FOOL
Published: November 26, 2024
Q: Is there an upside for shareholders if a company repurchases its stock? -- C.B., North Carolina
A: There definitely can be, because when the number of shares is reduced, each remaining share of stock has a bigger stake in the company. Imagine a pizza cut into eight slices and one cut into six slices. The second pizza's slices will be bigger.
A company should buy back (and retire) shares only when they're undervalued, though. If it buys back shares when they're overvalued, it will get fewer shares for its money and will be wasting shareholder assets that could have been better spent paying dividends or investing in growth.
Here's a simple illustration of how buybacks work: Imagine that Scruffy's Chicken Shack (ticker: BUKBUK) earns $100 million annually, and has 100 million shares outstanding. Its earnings per share (EPS) are thus $1. If it buys back a 10th of its shares, leaving 90 million, then its EPS suddenly rises to $1.11 ($100 million divided by 90 million).
When you study a company's financials, it's important to see earnings growing mostly due to business growth, not share buybacks. You can examine its statements of cash flow for amounts spent on buybacks -- or look up news reports on them. Checking the income statement to see if the share count has been dropping is another approach.
Q: What's a mutual fund's "load"? -- L.D., Saratoga, New York
A: It's essentially a sales charge or commission, usually charged when you buy into the fund. Loads can be as high as 8.5%, but 1% to 2% is more common. Fortunately, there are plenty of funds that don't charge them -- so these days the lion's share of mutual fund dollars go into no-load funds.
Fool's School
Appreciating Dividends
Dividend-paying stocks aren't just for retirees. They can be powerful wealth builders for investors of all ages and experience levels -- offering, ideally, both income and share price appreciation.
Consider this data from Ned Davis Research and Hartford Funds, shared by the latter: Between 1973 and 2023, among the companies in the S&P 500, dividend payers averaged annual gains of 9.17%, compared to only 4.27% for non-payers -- and payers exhibited less volatility. That's partly because dividend-paying companies have often reached a stage with fairly reliable income, and management is comfortable committing to a regular payout to shareholders. Here are some other things to know:
-- Dividend income can be used by retirees for living expenses, but younger folks can use it, too, by reinvesting those dollars into more shares of stock.
-- If Company A has a dividend yield of 2% and Company B has a yield of 4%, Company A might end up paying more in lifetime dividends if it's increasing its payout at a faster clip. Slower-growing companies may raise their dividends by only 0% to 3% each year, while others might be hiking their payouts by an annual average of, say, 15%. Always check a dividend's growth rate.
-- Note that particularly high dividend yields are sometimes (but not always) tied to companies in trouble, so tread carefully. A dividend yield is the company's total annual payout per share divided by its current price per share -- so if the stock's price drops, the yield rises. Take a close look at any high-yielding companies to make sure they're healthy and growing.
-- Look beyond a company's dividend to make sure the business is a high-quality one, ideally with little debt, ample cash and growing sales, earnings and profit margins.
You can easily invest in a wide range of dividend-paying stocks via exchange-traded funds (ETFs) such as the Schwab U.S. Dividend Equity ETF (SCHD), iShares Core Dividend Growth ETF (DGRO) or Vanguard Dividend Appreciation ETF (VIG).
My Dumbest Investment
Catching a Falling Knife
My most regrettable investment move happened in 2000, after I'd bought into the optical networking stock Corvis around its initial public offering (IPO). The regrettable thing was that I kept buying shares as the price plunged -- trying to "catch a falling knife," as they say. Fortunately, I've done well in the past 20 years by investing in index ETFs and sector ETFs. -- R.H., San Diego
The Fool responds: Initial public offerings can be risky investments, often soaring in the first days and then falling below the offering price later. Corvis had investors so excited that they snapped up shares when it went public -- even though it hadn't yet generated a dollar of revenue.
At the IPO, the company was valued near $28 billion. Corvis bought Broadwing Communications in 2003, began using the Broadwing name, then in 2007 was itself bought by Level 3 Communications for around $1.4 billion.
It's best to be careful when a stock is falling -- and to buy only when you understand what's going on and are confident of a recovery. We're delighted that you've gone on to discover the solid growth potential of index ETFs, such as those based on the S&P 500 index, and sector ETFs -- which each invest in a range of companies within a certain sector, such as communications or health care.
(Do you have a smart or regrettable investment move to share with us? Email it to TMFShare@fool.com.)
Foolish Trivia
Name That Company
I trace my roots back to 1927, when I was founded in Augusta, Georgia, as a hardwood lumber wholesaler. By 1938 I had five sawmills in the South, and I expanded to the West Coast in 1947. I was listed on the New York Stock Exchange in 1949, but I've since been taken private, so you can't buy stock in me. I'm a top global maker and seller of bath tissue, paper towels and napkins, tableware, paper-based packaging, cellulose and building products. My brands include Angel Soft, Brawny, Dixie, enMotion, Quilted Northern, Sparkle and Vanity Fair. Who am I?
Last Week's Trivia Answer
I trace my roots back to 1845, when a father and son in Switzerland produced a chocolate bar. Some decades later, their business joined with another, and I was born -- enjoying success in part due to a novel "conching" process for refining chocolate. I joined with other chocolate makers over the years. My brands today include my namesake, along with Ghirardelli (founded in 1852), Russell Stover (1923) and Whitman's (1842). My wares are sold by 36 subsidiaries and regional offices, more than 100 independent distributors and 500-plus stores of my own. I rake in more than $6 billion annually. Who am I? (Answer: Lindt & Sprungli)
The Motley Fool Take
Consider Nvidia
Nvidia (Nasdaq: NVDA) shares have surged in value by more than 180% over the past year as of this writing. That might make you think you missed the Nvidia boat. But that's not necessarily true -- especially if you're a long-term investor.
The company continues to report phenomenal growth. Demand is coming from consumer internet services and from thousands of startups building AI applications across health care, advertising and education. Data centers are increasingly in need of Nvidia's graphics processing units (GPUs) as they handle growing artificial intelligence (AI) workloads.
In addition, the company will likely see rising demand from government customers. Nvidia has highlighted the importance of having "sovereign AI" (based on each nation's own resources) as a key national priority for governments around the world, and spending from public sector customers is likely just beginning to ramp up.
Nvidia also has major new product releases set for the fourth quarter. The first of its Blackwell processors is expected to provide major performance and power-consumption advantages compared to its current top-of-the-line processors.
The Blackwell processors could help boost profit margins -- or the company could price the new hardware aggressively to stamp out opportunities for competitors. So while there's uncertainty about what the broader market will do in the near term, Nvidia's competitive positioning in AI continues to look very strong and opens the door for excellent returns. (The Motley Fool owns shares of and recommends Nvidia.)
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