Chingo De Dinero

One important aspect of outstanding shares which I think many people miss is a simple math problem.

What is better for earnings per share…10% earnings growth, or 10% reduction in outstanding shares?

The answer the buy back. The reason why, when you calculate the percentage, you use the original amount for the denominator, so when the amount is decreasing you get different results then when it is increasing.

What sparked this question was building the model for MSFT earnings. With the large amount of stock they are buying back, I wanted to see how this would affect earnings per share. My basic thought was if they grow earnings 10% and buy back 10% of the outstanding shares (actual will be less than this 5-10%), then EPS grow at 20%. Well this is not true, if you do the math, it is actually over 22%. Maybe 2% is not much to you, but if they keep at this pace, and the amount of buy back grows, this difference becomes larger and larger.

Stock splits are not important!!!!

Stock splits are a simple mathematical action.  You divide the price by two and multiply the number of shares by two.  Of course, if you own a stock, it doubles, the stock splits, and now you have twice as many shares at the same price…that is very good.  But, it is no better than having the same number of shares that are twice as valuable than when you originally purchased.  It should have no affect on what the company is worth, or how the price will move in the future.

So…the first thing that you need to know when investing is how do stocks move….can you look at charts and predict movements….what makes them go up or down.  The movement of stocks is best described, in my opinion, by the weiner process.  The Weiner Process can get pretty complicated, but you really do not need to totally understand it, just have a feel of what it means.  It is a continuous time stocastic process (stocastic=random).  So, what I am saying is stocks are totally random from one second to the next, also described as a random walk, this was popular in a book a few years ago “Random Walk Down Wall Street“.  Also, this is ingrained in the idea of an “Efficient Market”.

Alright, so I said a bunch of stuff above, but to get to the point, stocks move in a random way, based on new news (White noise when modeling).  So…the only to know where a stock will go one second from now is to know the future.  No need to look at charts, or any trends, it is all random.  But, I will contradict myself and say that you can swing the odds a little in your favor if you do your homework and stick to certain principles.