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Why do companies buy back their own shares?

Is this a good sign, as they think the price is quite low?  Or is there a bearish reason why companies might do this?

If a company is quite profitable and has generated a huge amount of cash, and it’s sitting on this cash, the company needs to determine how it will be allocated.  It could use this money for investing in new projects, or to pay off debt, or leave it sitting in a bank account, or it could pay out as dividends to investors.

The company has to decide what the best return will be for their cash.  They will consider different projects (eg. buying new factories, refurbishing head office etc) and then calculate whether the investment will generate a decent enough return to justify using the cash.

So the company is asking itself, what shall I do with this money?

Often, they will have a look at their own compnay and realise the best place to invest the money is back into their own shares.

Effectively what the company is doing, is going back out into the market and saying, “I’m going to be buying back my own shares, because that is the best place to put this investment”.

There are differences of opinion here, because some investors will say, rather than buy back your own shares, why don’t you just pay it out as dividends to other investors?

It is a dilemma that a lot of companies are facing right now, because they have a lot of profits.  They have a lot of cash sitting on the sidelines, and they don’t know what to do with it.  Ideally it would be great if they reinvested this money back into the economy, and make their businesses grow, but they’re saying, we don’t know whether or not the returns from those are going to be justifiable to investors.

So some companies are thinking let’s just go back and buy our own shares. Or some of them are saying, let’s just give a special dividend to investors.

What is means is that they’ve got too much cash.

Many investors (and professional analysts) have been expecting Telstra (ASX: TLS) to buy back a larger chunk of it’s own shares. Property groups such as GPT Group (ASX: GPT), and Stockland (ASX: SGP) are currently buying back shares, as has CSL (ASX: CSL).

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The Motley Fools purpose is to help the world invest, better. Take Stock is The Motley Fool’s free investing newsletter. Packed with stock ideas and investing advice, it is essential reading for anyone looking to build and grow their wealth in the years ahead. Click here now to request your free subscription, whilst it’s still available. This article contains general investment advice only (under AFSL 400691). Authorised by Bruce Jackson.

A version of this article, a podcast by David Kuo, originally appeared on fool.co.uk

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