A WSJ article notes that Microsoft is planning to buyback $40 billion dollars worth of its stock. Why do companies do that? The basics:

• Once reacquired, the stock becomes treasury stock unless retired by the company, which was not noted in this case.
• Buybacks typically occur over a period of time — 5 years in this case — and are intended to be interpreted as companies believing that their stock price is under-valued. However, as John Waggoner of USA Today has noted, a better indicator of whether a stock is under-valued is to notice if company directors are also purchasing the stock.
• For example purposes – although buybacks don’t occur at once – let’s assume they do in the case of Microsoft. The market capitalization of $230 million would be unchanged, but the outstanding shares would decrease by about 17% – from approximately 9.1 to 7.5 million shares outstanding. The theory is that the remaining outstanding shares would be worth more.
• Buybacks benefit option holders by reducing the required dividend payments, which option holders do not participate in.
• Stock buybacks can represent a more tax efficient method to benefit shareholders since the increased value of the stock is not taxable [until sold], as opposed to a dividend, which is taxable.

With the help of The Motley Fool, we’ll walk through an example:

Let’s look at the math via a simplified example. Imagine that Scruffy’s Chicken Shack (Ticker: BUKBUK) has 100 shares outstanding, and you own five of them, or 5% of the company. (This is really simplified. Black & Decker (NYSE: BDK), for example, recently had more than 60 million shares outstanding; 100 shares is approximately one 600,000th of the company.)

If Scruffy’s bought back 10 shares, 90 would remain. Assuming you still held your five shares, they would now represent 5.6% of the company. Your ownership stake has gone up, and each share is tied to a bigger piece of the company.

Think of the firm’s earnings per share (EPS), for example. If its net income for the year was $600, pre-buyback the EPS would be $6. After the buyback, the net income would be divided by 90 shares, yielding an EPS of $6.67.

Buybacks thus increase the earning power of your investment by increasing the amount of the company each share represents.

All articles referenced are copied in full at end of post.
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Will Stock Buybacks Make You Rich?

http://www.fool.com/investing/dividends-income/2008/04/17/will-stock-buybacks-make-you-rich.aspx

Selena Maranjian
April 17, 2008

Stock buybacks have a great reputation for being a powerful way for shareholders to build wealth, and they’ve been especially popular lately.

According to a December 2007 Standard & Poor‘s report, stock buybacks have become one of the largest expenditures that S&P 500 companies make. In the past three years, companies have bought back around $1.32 trillion in shares, beating out capital expenditures ($1.28 trillion), regular dividends ($600 billion), and research and development ($375 billion). In the third quarter of 2007, buyback levels had increased 57% year over year.

So what exactly is a share buyback? Well, when a company makes a hefty profit, it can spend that money on growing the business, paying down its debt, rewarding employees, or rewarding shareholders through a dividend payment. It can also buy some of its existing shares on the open market and then essentially retire them: the share buyback.

The good side
Why are buybacks good for investors? Let’s look at the math via a simplified example.

Imagine that Scruffy’s Chicken Shack (Ticker: BUKBUK) has 100 shares outstanding, and you own five of them, or 5% of the company. (This is really simplified. Black & Decker (NYSE: BDK), for example, recently had more than 60 million shares outstanding; 100 shares is approximately one 600,000th of the company.)

If Scruffy’s bought back 10 shares, 90 would remain. Assuming you still held your five shares, they would now represent 5.6% of the company. Your ownership stake has gone up, and each share is tied to a bigger piece of the company.

Think of the firm’s earnings per share (EPS), for example. If its net income for the year was $600, pre-buyback the EPS would be $6. After the buyback, the net income would be divided by 90 shares, yielding an EPS of $6.67.

Buybacks thus increase the earning power of your investment by increasing the amount of the company each share represents.

Over the past few years, plenty of well-known blue chips have executed sizable stock buybacks.

Source: Standard & Poor’s.

But wait!
Although stock buybacks seems like an unqualified benefit, there’s the potential for downside. If the shares are bought back when they’re trading at inflated prices, then the company isn’t doing its shareholders any favors. In fact, it’s destroying value.

Sometimes buybacks are executed simply because it will look good, conveying management’s confidence in the company, when there are actually better uses of the funds.

But more importantly, the conventional wisdom about the worth of share buybacks may not hold water. A recent S&P study noted that many believe that stock prices rise from buybacks, that more buybacks have a bigger impact than fewer buybacks, and that buybacks reduce total shares outstanding. Yet S&P’s Equity Research Services actually looked at the data from the beginning of 2006 to the middle of 2007 and concluded that none of those three points was supported by the actual figures. Yikes!

What to do
Since buybacks may not be so effective, what should you do? Well, investigate how promising one is before getting excited about it. And also…

Consider dividends instead! As my colleague James Early has pointed out in his article “Make Millions with 7 Stocks,” the vast majority of gains from stocks over the past 130 years have come from reinvested dividends. Furthermore, high-yielding dividend-paying stocks often have higher earnings growth than their lower-income counterparts.

Why do dividends seem like a more reliable path to wealth than buybacks? Well, remember that buybacks are executed by managements that are often trying to look good to the public. Dividends reflect more of a long-term commitment. No company wants to ever lower or eliminate its dividend, so it isn’t likely to overpay them. Companies know that raising dividends regularly is attractive to investors, so they try to do that, too.

For help finding significant dividend payers, I invite you to check out our Motley Fool Income Investor newsletter, which recommends two compelling investments each month. Last time I checked, its recommendations were beating the market with average returns of 21%, vs. 14%, and there were more than 20 recommendations with dividend yields topping 6%. A free trial will give you access to all past issues and all recommendations — it’s worth a look.

Learn more in these articles:

• Stocks for the Rest of Your Life
• The Best Returns Possible
• How to Buy a Million-Dollar Stock

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WSJ 9/22/08
Microsoft Boosts Stock Buybacks
By KERRY E. GRACE

Microsoft Corp.’s board authorized the repurchase of $40 billion in stock and an 18% dividend increase as personal-computer giant Hewlett-Packard Co. announced another $8 billion buyback.

The moves by the two technology titans, coupled with Microsoft’s plans to tap the debt market for the first time — show that they aren’t concerned about the turmoil roiling the financial markets.

Microsoft CEO Steve Ballmer has continued investing in online services despite the failed Yahoo bid, but the stock buyback signals the software maker isn’t planning any big acquisitions.

Microsoft’s latest buyback effort also signals no big acquisition plans on the horizon — such as its effort earlier this year to acquire Yahoo Inc. — and comes after Microsoft said in 2004 that it would repurchase up to $30 billion in stock over the next four years. That plan ultimately grew to $40 billion and has been completed.

The next $40 billion is set to be purchased over the next five years. Microsoft’s market capitalization is about $230 billion.

The company noted Monday that in the past five years, it has returned about $115 billion to shareholders through buybacks and dividends. That is solace to longtime shareholders who own a stock that has traded below $30 for essentially all of the past 6 1/2 years.

Microsoft’s board also approved taking out up to $6 billion in debt and the establishment of a $2 billion commercial paper program. Microsoft will use the proceeds from any debt financing for general purposes, including the stock buybacks. The company has no debt.

Also Monday, Standard & Poor’s and Moody’s bestowed Microsoft with AAA, their highest rating. It’s S&P’s first new AAA rating in a decade and Moody’s first since 2002. Microsoft is one of only six nonfinancial companies to receive an AAA rating from the firms.

S&P said Microsoft’s size, scope and low risk contributed to its rating, adding that the AAA category would likely continue to get smaller as part of the “expected ongoing trend toward reduced credit quality.”

Meanwhile, H-P’s $8 billion buyback plan is intended to manage dilution created by shares under employee stock plans. The amount is in addition to the nearly $3 billion that can be repurchased under the $8 billion stock-repurchase program approved in November. The company’s market value is just short of $120 billion.

Write to Kerry E. Grace at kerry.grace@dowjones.com
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