Capital allocation is one of the key metric that gives a good indication of management efficiency and insight on fundamentals. There are different ways to do this - such as dividend payments, reinvestment in the business and so on. But perhaps none of the above generates so much activity and volatility as a Stock Buyback decision does.
So what prompts management to announce buybacks?
There could be different motives, with different merits. The one that makes sense from investors' point of view and is also genuine is buying back share when the market values the stock at a price lower than intrinsic value. The buy back decision in such cases suggests that the management is quite confident about the business prospects. And that it expects them to be reflected in valuations over time.
However, there is no dearth of cases where stock prices post buyback have eroded shareholders' wealth. Thus suggesting that not all buy backs create value. As an article in Economic Times suggests, in around 58% of the cases when buyback was announced, the stock prices have under performed Sensex. So how should investors react to buy back announcements?
One must note that post buyback, the outstanding number of shares come down. This makes the return ratios look better and valuation ratios (such as price to earnings) attractive. While it is obvious that these have got nothing to do with fundamentals, there is generally a positive perception about the buyback process. And the unscrupulous managements have exploited this impression by announcing buybacks even at high valuations, in order to make return ratios look good and use market reaction to support share prices. What this leads to generally is a run up in share prices, followed by poor stock performance. The worst victim in such cases is the naive investor. The latter does not analyze buyback intentions well and gets trapped by what seems like an opportunity to make quick money.
Hence, next time you come across a Buyback announcement, focus on the intentions behind the buyback. Do not think of it as a means for making a quick buck. Remember, buyback or no buyback, successful investing is all about fundamentals, valuations and disciplined approach.