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Published On: Fri, Nov 7th, 2014

How to Exploit Stock Buybacks and Stock Splits for Profit

A stock buyback occurs when a company’s cash is used by it to repurchase shares back from the market. In a stock split, one share is divided into two.

A stock buyback occurs when a company’s cash is used by it to repurchase shares back from the market. Repurchased stocks are canceled, or made treasury shares. The buyback decreases the amount of equities in circulation, and as a result their value rises, though sometimes temporarily.

Stock buybacks, when based on the correct motives, can be exploited for profits. Sometimes companies repurchase equity because they believe the latter is greatly undervalued and seek to increase shareholder value. However, when the repurchase is done solely to improve specific metrics, and in fact no material change occurs, that may send a negative signal to investors and trigger a selloff of the specific share.

Stock buybacks by companies having a solid balance sheet provide good investment opportunities; in these cases, the share repurchase is seen by investors as positive. Investment should never be made with the hope of certain events occurring in the future. Share buybacks are often implemented for solid reasons.

In a stock split, no value is added. Instead, one share is divided into two. Hence the total value is not altered, but current shareholders obtain twice as many shares at half the individual value each. The 2-1 split is the most common one, but other ratios can be applied as well, depending on the price. With higher price stocks, splits can be done enough times, to reduce the price per share to below $100, so that liquidity is enhanced.

Splits often serve as a bullish sign: when valuations become excessively high, the specific stock can be unobtainable for smaller investors seeking diversity. When investors own stock that splits, immediate profits are not always likely, but the split is a positive signal, and such stock should not be sold in most cases.

There is also a reverse stock split, which is implemented in the opposite direction. This one should be treated with caution because sometimes businesses implement reverse stock splits to improve the look of small priced shares. In such cases, often companies do not achieve much.

In a nutshell, everything else equal, with stock split purchasing can be recommended, and with reverse split selling is advisable.

To sum up, stock splits and stock buybacks provide investors with metrics for gauging management sentiment of their company. With such actions, balance sheets should be reexamined as well.

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