Thursday, February 28, 2008

IBM buys back stock - if EPS goes up - should the price?

IBM is in the news because they are planning to buy back a lot of stock $15bn or so. The stock went up on the news. But why? Well buybacks, especially big ones can signal that the firm has a lot of cash or is going to get a lot more cash - thus will be making loads in the future. Buy backs are also good news for firms with cash sitting around. That money is better off in the hands of shareholders rather than being used for some dubious project.

But the reason why the stock price shouldn't go up is due to an increase in earnings. EPS will rise after a buyback purely because shares outstanding (the denominator in the EPS) went down. But net income (the numerator) is unchanged. I suspect that there are a lot of analysts who fix upon a valuation multiple - say 20X earnings, and apply that multiple to any EPS number that comes along. Thus by their reckoning, IBM's price should go up because the EPS went up. This is completely wrong, and frankly pretty stupid.

Link here