Delta Widget, Inc. has just made you a tender offer to buy back its shares of stock, which you bought from your broker a few years ago. The stock price hasnt grown as expected and the tender offer is just slightly over market value. It's tempting to take the offer. On the other hand, when Delta Widget buys its own stock back, there will be less stock outstanding, and that could help boost its price.

The dilemmas of investing - will they never cease?

To weave our way through this problem, lets first examine the two ways a company can initiate a buyback program, or "stock repurchase agreement" as it's often called. The first way is to make a tender offer to its shareholders. A "tender offer" is simply an offer to its current shareholders to "tender" (i.e., sell) some portion of their shares back to the company. The company states the number of shares it is willing to buy, at what price, and for what period of time. This is one way that is often used to buy back stock from smaller shareholders.

The second way is for the company to buy its own stock on the open market, at whatever market price the shares command. When the company announces this type of program, it will usually state the number of shares it offers to buy, and the length of time it will keep the offer open.

If Delta Widget, Inc. were to announce such a program, it might announce that it intends to buy back $50 million worth of its stock over a two-year period. Since the company doesnt know what the price per share will be over the next two years, the repurchase program will be expressed as a dollar amount rather than a set number of shares.

Whatever method is used by a company, the real question is why the company wants to buy back its stock in the first place?

The answer to that question is rather simple. Let's suppose that, before the buyback, Delta Widget had a market capitalization of $250 million, that it had 10 million shares outstanding, and that the market price per share was $25.00. Under this scenario, each share of stock would represent .0000001 of company ownership.

If the company spends $50 million to buy its shares back at $25 per share, it will be able to repurchase 2 million of its shares. That will leave 8 million shares outstanding. In that case, each outstanding share would then represent .000000125 of company ownership. Theoretically, the price per share would then be $31.25 (8 million x .000000125). Not a bad increase at all!

Naturally, not all companies are motivated to increase share value in this manner. Instead, a growing reason for repurchase plans is to reduce the number of shares outstanding, as opposed to increasing the price per share. Companies that have liberally doled out stock options to employees in the past, now find themselves offering buyback programs because the exercise of the stock options has increased the number of the company's outstanding shares. An increased number of outstanding shares can adversely affect important ratios, like earnings per share and price/earnings (P/E), all of which can negatively impact share price.

A repurchase plan can also cause problems if a company overpays for its own stock. If natural market forces or a business downturn creates a decline in stock price, the company will not only have failed to increase stockholder value, but it also will have consumed much-needed capital, capital that could have been used for other business purposes.

In the final analysis, the evaluation of a stock buyback plan is nothing more than an evaluation of the company itself. If the company's stock price is undervalued and buying back some stock will result in an overall reduction in the number of shares outstanding, then holding on to your shares could be a good bet. On the other hand, if it appears that company management is trying to manipulate the stock price to make the company appear better than it really is, then you should think about divorcing yourself from the company.