There are several metrics I use to identify undervalued stocks. One of my favorites is share buybacks.

When companies spend millions of dollars buying back their own shares, it’s a powerful signal.

Management is telling you that the best use of cash on hand is not building more factories or buying up competitors.

[ad#Google Adsense 336×280-IA]It’s retiring outstanding shares.

Some folks might grumble that this is an easy decision to make. After all, officers and directors are using the firm’s money, not their own.

But let’s not be hasty.

If management decides to spend hundreds of millions of dollars buying back company shares with company money and it turns out to be a bad decision – something that will be readily apparent soon enough – it could mean curtains for their careers.

So Board Members and Chief Executives don’t take this decision lightly. A major share repurchase plan is a strong vote of confidence for the near-term prospects of the business.

The second major reason share buybacks are vital is they increase earnings per share. How? When you take the company’s net profits and divide them by a smaller number of shares outstanding, you get stronger growth in earnings per share.

Better growth in earnings per share translates into higher stock values. After all – and this should be your mantra – share prices follow earnings.

Just how much are companies spending to buy back their own shares? More than you might imagine.

It’s estimated that U.S. companies will spend approximately $2.6 trillion in 2017. A little over half of it will be for capital investments, research and development, and mergers and acquistions. About 18% will go to shareholder rewards in the form of dividends.

But Goldman Sachs estimates that companies in the S&P 500 will spend about $780 billion on share buybacks this year. That’s 30% more than last year. And it will account for the greatest percentage of cash use for major companies for just the second time in 20 years.

Of course, it’s simplistic to believe a company can make a share buyback announcement and you can safely plunk for a few shares yourself. (If only life were so simple.)

Some companies announce their intentions to buy back shares and then don’t follow through. If business conditions change, interest rates rise or cash flow decreases, you may find that the repurchase program never gets completed.

The other thing to watch is the exercise of stock options. If a company is buying back enough shares only to offset the dilution that occurs when executives exercise stock options, you won’t see the buyback boost earnings per share.

But, generally speaking, share repurchase programs are a good thing. And right now, with money cheap and corporate earnings up, buybacks are occurring at record levels.

Corporations are so flush with cash – more than $2 trillion – that they need a place to put it to work.

Rather than return that cash to shareholders in the form of taxable dividends, why not plow it back into the stock and give the stock a boost? That way, there are no taxes to pay until the shares are eventually sold.

Right now, a number of companies are in the midst of major repurchase plans, including Gilead Sciences (Nasdaq: GILD), Apple (Nasdaq: AAPL), General Electric (NYSE: GE), Pfizer (NYSE: PFE), McDonald’s (NYSE: MCD), Microsoft (Nasdaq: MSFT) and Boeing (NYSE: BA).

If you’re looking for companies that will report better-than-expected earnings per share – the biggest short-term driver of share price apprecation – these stocks deserve a closer look.

Good investing,

Alex

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Source: Investment U