After 2022’s price action, I think we can say that when the Fed pulls away the punchbowl, things can get ugly.
When interest rates rise, it can signal that inflation is running hot… meaning consumers might change their behavior.
It also means debt costs for corporations will increase, so they can’t use a ton of leverage to finance operations.
There’s one other financial engineering trick that’s really throwing the wrench into things.
There are a few ways for a company to return value to its shareholders.
- Issue a dividend
- Sell the company to a larger buyer, or…
- You can buy back shares of the company.
Now consider this: Earnings Per Share (EPS) can change by adjusting the earnings number…
Or the share count.
If you reduce your share count and hold earnings equal, your EPS goes up. Simple math.
It can also nudge the stock price of the stock higher.
See what’s happening here? A company buying back its own stock boosts its stock price without creating value or getting real demand from market participants.
Now, here’s where it gets interesting:
When there’s a ton of liquidity and easy money, a corporation can use debt as a form of leverage.
Say you’ve got a company with 100 million shares earning $1 billion a year. The value of those shares will be a function of many things, but ignore all that for now.
We’ll just say it has an EPS of 5, putting the company’s valuation at $5 billion.
In this case, the share price would work out to $50/share.
If the company doesn’t want to reinvest sales proceeds into growth, it could buy back shares on the open market.
Say they use $50 million of their sales revenues to buy back stock.
At a $50 share price, they could buy back 1 million shares. This would offer a decent boost to the share price since they’re taking away 1 million shares.
If they use the debt markets, they can secure a $500 million loan by putting $50 million down and financing the rest at a 3% yield.
If they have enough free cash flow to easily cover the monthly financing cost, they can use that leverage to buy back far more company shares.
That buyback mechanism can easily create a strong upward drift in a stock’s price because that’s a ton of demand on the margins.
Now… if the Fed’s hiked rates, you can’t borrow at 3% anymore.
You have to borrow at, say 6%… assuming you can find a lender now that credit markets have tightened.
Oh, and odds are you can’t service the debt as easily when your interest rate has doubled.
That’s how latent demand in the market can continue to drop, leading to the kind of garbage price action we’ve seen recently.
Want to know one more dirty secret about buybacks?
They don’t always buy back these shares on the open market.
Sometimes, they just buy them from themselves — and I mean high-level corporate insiders.
Management will get stock compensation, then issue a “stock buyback” where the company repurchases the shares from them at a much higher price.
They get a cut of risk-free profits.
Sounds corrupt to you?
This kind of stuff is legal. And you bet that insiders time these things to sell once the price has increased as much as possible.
But the good thing is we can follow many types of trades these insiders make, and if the trade moves the right way, bag some healthy profits.
Watch this webinar to learn how.
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