Most workers trade their time for money, commonly referred to as an hourly wage. CEOs and other highly paid individuals who bring wealth to their organizations through decision making, leadership, or long unorthodox work schedules can’t be properly compensated on a per hour basis. Instead of paying them outrageous wages that would be highly taxed, these high earners are instead compensated with (stock) ownership in the company.
Since CEO’s are paid mostly through stock instead of wages or salary, they are essentially rewarded for their leadership and decision making every time the company stock price increases. Contrary to the buy low and sell high mantra that states investors should buy a stock that is decreasing in value or has recently decreased in value, most investors generally purchase stocks when they are “hot” or increasing in value.
Professionals and smart investors on the other hand tend to buy a stock only when it is offered at a discount or when the company is actively buying its stock back from retail investors. When companies use their earnings to buy their own stock back, it’s a sign that the company believes that its stock is being valued cheaply. When a company buys its stock back it usually does so with the intent of retiring the shares, issuing them to employees, or selling them on the stock market for a profit.
Stock buybacks create wealth in two ways, the first being supply, and demand. The more stock the company buys back (takes out of the market) the higher the demand for the outstanding stock will be and as a result, the stock price should rise. Another effect of stock buybacks is the illusion of increased Earnings Per Share or EPS.
Unissued stock or shares that the company has bought back are called treasury stock shares and are not calculated as a part of the company’s EPS because EPS is calculated by dividing the company’s quarterly earnings by the number of outstanding shares. The relationship between EPS and treasury stock shares is the reason stock buybacks tend to make the company appear more profitable.
The second way stock buybacks increase the share price is it incentivizes employees and CEO’s who have been rewarded with stock to continue to work efficiently and to keep making decisions that benefit the company’s share price. Illegal insider trading occurs when you make a profit or avoid a loss by exploiting proprietary or non-publicly available information. It is completely legal to make trades based on publicly available information even if that information isn’t widely distributed.
Company insiders are required to disclose their trading activity to the Securities and Exchange Commission (SEC). These filings are publicly viewable on the SEC’s website. One legal insider trading strategy is to find out when a company’s officers, directors, or any major shareowners who own more than 10% of the company buys or sells stock in their company.
Unfortunately, this legal insider trading strategy only works when an insider is buying stock, because people sell stock for all kinds of reasons (new house, new car, vacation, taking profits, lawsuits) but they only purchase stock if they believe that it is going to rise.
This post was created to explain how CEO’s are compensated through the use of stock buybacks and to explain how those stock buybacks affect investors. At Pocket Change Investments we believe that information can only be as credible as the source from which it originated. As a reader we challenge you to do your own research, check our receipts, and join the conversation.
- SEC 2013 INSIDER TRADING POLICY https://www.sec.gov/Archives/edgar/data/25743/000138713113000737/ex14_02.htm
- Stock Buybacks: A Breakdown By Cory Janssen //www.investopedia.com/articles/02/041702.asp