What is a stock buyback?
A stock buyback (also known as a share repurchase) is a process when a company buys back its shares from the marketplace, therefore reducing the number of shares that are outstanding. Because there are fewer shares on the market, the value of each share increases, making each investor’s stake in the company greater. Much like a dividend, a stock buyback is a way to return capital to the shareholder. A dividend is essentially a cash bonus equal to a percentage of an investor’s total stock value; however, a stock buyback will require the investor to surrender stock to the company to receive cash. Those shares are then removed from circulation and taken off the market.
How do stock buybacks work?
Simply put: stock buybacks improve a company’s financial ratios (used by investors to determine the value of a company). By repurchasing its stock, the company decreases its outstanding shares on the marketplace, without actually increasing its earnings. Therefore enabling it to increase its metrics, the most important of which is EPS (earnings per share). EPS divides a company’s total earnings by the outstanding shares, the fewer the shares of course, the higher the earning per share – a higher number points to a more robust financial position. Example: Let’s imagine a company has 100,000 shares outstanding, at 50 dollars per share for a total cash outlay of 5 million dollars. In the eyes of the management, this does not express the true value of the company and they decide to initiate a buyback to up the price of the stock. They use 1 million dollars of cash from net profits to purchase 20,000 shares at market value. This decreases the total outstanding shares to 80,000. Each share now represents 0.00125% ownership (instead of 0.001% ownership at 100,000 shares), which is a 20% increase in total value per share.
Why would a company buy back its own stock?
Other uses for excess capital include:
Paying cash dividends to shareholders; Reinvesting in the company to grow their business operations, e.g. buying new equipment or property; investing in research; Acquiring another company or business unit.
Recommended video: What are Stock Buybacks and why are they controversial?
How to make a buyback?
There are two ways companies conduct a buyback: a tender offer or through the open market.
How is stock buyback beneficial for investors?
Unlike cash dividends, stock buybacks do not offer an immediate, direct benefit to shareholders. However, investors do benefit from a company’s stock repurchase as the goal/outcome is generally to raise the company’s stock value. As fewer shares circulate on the market, the more a share is worth. In addition, shareholders pay income tax on stock dividends, stock buybacks, on the other hand, are taxed at a lower capital-gains tax rate. As such, shareholders do not owe taxes on capital gains resulting from stock buybacks until they realize those gains, meaning when they sell the shares. If the investor of the stock holds onto those shares, they can avoid paying taxes on the gains for years or decades. Still, using this tool does not come without risks. Sometimes a mere announcement of a company’s plan to repurchase its shares, skyrockets the stock price. Other times, however, a shift in the market as the company is repurchasing its shares, can compromise the share value. All in all, though, a share repurchase program will likely improve the stock’s price over time. Not only because of the reduced reserve of the shares but also because it boosts some of the metrics that investors use to evaluate a company.
Downsides to share repurchases
There is some valid criticism about the fact that companies often repurchase their shares after a period of great financial success, typically at a time of high valuation. A company in that situation could end up buying its shares at a price peak, settling for fewer shares for its money, and leaving less in the reserve for when business slows. Investors should also be wary if the buyback seems to be motivated by the board’s desire to manipulate valuation metrics. What is more, some companies will borrow money to fund a stock buyback, and a debt-based stock buyback can negatively influence a company’s cash flow. Indeed more than half of all buybacks are financed by debt.
Do stock payments benefit the economy?
Even though the primary impact of a stock buyback is to increase the value of that stock, there are numerous benefits to the economy at large. The data show that over half (56%) of US citizens now own stock at some capacity, whether it be via pensions, 401ks, or investment accounts, all of which benefit both from dividends and higher stock prices. Moreover, the money returned to shareholders via dividends or stock buybacks does not just disappear from the economy. Rather, it often finds its way to growing new businesses or is used to finance emerging technologies.
In conclusion
All in all, a share repurchase will always grow the value of the company’s stock and therefore be beneficial to the shareholders. However, as an investor it is important to understand the motives of such a move, so the true value of the company can be determined.
