A stock buyback is when a company purchases or “buys back” stock from its shareholders. It’s sometimes called a share repurchase. The company buys shares of its own stock at the market price, thereby reducing the number of shares that are outstanding. Since the value of the company stays the same, the result of a buyback is usually an increase in the share price.
How Does a Stock Buyback Work?
When a company chooses to buy back, or repurchase, stock, it can do so in one of two ways. The first is to simply buy its own shares on the open market. The second way is a tender offer, in which the company informs its shareholders that it wants to purchase shares, and at what price.
Each investor can decide if they want to sell shares at that price. In some cases, the tender offer will include a price range, and interested investors can name their price within that range. The company will purchase the shares at the lowest cost.
What Happens to the Share Price?
A stock buyback typically means that the price of the remaining outstanding shares increases. This is simple supply-and-demand economics: there are fewer outstanding shares, but the value of the company has not changed, therefore each share is worth more, so the price goes up.
XYZ Company has 1,000,000 shares of stock outstanding. The current trading price of the stock is $10 per share, giving XYZ Company a market capitalization of $10,000,000. The company is flush with cash, so the board of directors decides to buy back 200,000 shares of its stock. There are now 800,000 shares of stock outstanding, but the company is still ‘worth’ $10,000,000, so the shares should now trade at $12.50 each.
The impact of this stock buyback is that the company has reduced the number of outstanding shares, and it has also increased the value of those shares. Since shareholders look for their investments to increase in value, this is a boon to the shareholders.
Of course, the price of any stock is driven by the market supply and demand. When there are fewer shares available, there should be more demand, and the price should go up. If a buyback is perceived by the market as a good move on the part of the company, the price could rise even more than the reduction in outstanding shares would indicate.
On the other hand, if the buyback seems not to be in the best interest of the company, the shares could increase less than the reduction in shares would indicate, or could even decrease over the short term.
Why Would a Company Buy Back its own Stock?
A company may buy back stock for one — or more — of three reasons:
- The company thinks the shares are selling at too low a price relative to the true value of the company. In this case, the buyback serves two purposes: it lets the company buy the shares at what it perceives as a bargain, and it typically increases the price of each of the outstanding shares.
- The company wants to invest in itself, retaining a larger share of the company for itself than it had prior to the buyback.
- The company wants to improve its financial ratios by having a smaller number of shares outstanding.
A stock buyback can improve a company’s financial metrics, making it more attractive to shareholders and merger or acquisition partners. Buying back stock reduces the amount of cash on a company’s balance sheet, which improves its return on assets metric. It also decreases the amount of equity, improving the return on equity metric.
Assuming that earnings remain consistent, having fewer outstanding shares will also increase EPS. Using XYZ Company as an example again, suppose the company has earnings of $54,000,000 in the quarter prior to the share buyback. With 1,000,000 shares outstanding, their EPS is $0.54. The quarter following the buyback, earnings are also $54,000,000, but because there are now only 800,000 shares outstanding, EPS is now $0.675.
Who Benefits from a Stock Buyback?
Stock buybacks are common among companies that have amassed a lot of cash. Companies often view stock buybacks as a way to return cash to investors. Other ways to use the excess cash to reward investors are to pay a dividend or to reinvest the money into the business by expanding operations or acquiring another company, which should result in appreciation of the stock price over time.
Is a Stock Buyback Good for Investors?
In most circumstances, a stock buyback is good news for those who already hold the stock. First, it usually means that the company has lots of cash, which is a good position for a company to be in. Secondly, a buyback will usually increase the stock’s price, so an investor’s position in the stock will be worth more money.
However, not all buybacks are good news for investors over the long term. Some companies will borrow money in order to finance a stock buyback, but this can make a company less attractive to investors. A debt-based share buyback can negatively impact a company’s cash flow. And if a company is borrowing to finance a buyback, it may mean that it needs to improve its financial ratios and is using a buyback to do that.
In the short term, a stock buyback will always increase the value of the stock.