A stock buyback, or share repurchase program, is a corporate action in which a company repurchases its own shares in the marketplace. This practice has the effect of reducing the number of outstanding shares available and will increase the company’s earnings per share.
This article will review the effects of stock buybacks for the company and the investor, and the reasons why company’s engage in stock buybacks. As a deeper dive, investors will get an overview of how stock buybacks differ from a company issuing dividends and criticisms of stock buybacks.
Stock Buybacks Are One Way to Return Capital to Shareholders
One of the simplest definitions of a company’s purpose is to provide value to their shareholders. After all, each share of a company represents an ownership stake in that company. One of the most tangible ways that publicly traded companies can provide value to shareholder is by returning capital to them.
One of the most common ways companies do this is by issuing dividends. This takes a percentage of a company’s earnings and returns them to their shareholders. Another way to accomplish this is through a stock buyback.
In a stock buyback, a company repurchases its own shares in the marketplace. This has the effect of reducing the number of outstanding shares available and will increase the company’s earnings per share. When earnings increase, the stock price generally rises as more investors become enthusiastic about the stock.
A company can execute a stock buyback in one of two ways:
- Direct repurchase from shareholders – in this scenario, a company will tender an offer to shareholders that specifies how many shares the company is looking to repurchase and a price range that the company will pay for those shares. This price range is typically above the stock’s current market price. Shareholders will respond to the tender by indicating how many shares they are willing to sell and the price they will accept for those shares. Once the company receives all their offers, they will proceed to execute the repurchases at the lowest cost.
- Buy back shares on the open market – in this scenario, the company simply buy their shares on the open market as if they were a retail investor. Although once a company announces that they are planning to buy back shares, their stock price tends to rise, which means the company may have to pay more than they were planning to execute the buyback.
How Does a Stock Buyback Affect a Company’s Fundamentals?
Although they are not necessarily the reason that companies issue a buyback, there are a few fundamental metrics that will change when a company issues a stock buyback.
- Its market capitalization decreases – Market capitalization is calculated by dividing the number of a company’s outstanding shares by the company’s price per share. In this way, by definition, reducing the number of outstanding shares will reduce a company’s market capitalization.
- Its earnings per share increases – Conversely, because a stock buyback reduces the number of outstanding shares in the market, a company’s earnings per share will rise.
- Book value per share decreases – since outstanding shares is the divisor for calculating a company’s book value per share, having fewer outstanding shares means that the accounting value of each share is less.
How Does a Stock Buyback Benefit Investors?
Ultimately, the net benefit of a stock buyback for investors is only realized if the company is correct in purchasing their stock back at a lower intrinsic value than what the stock’s future value will be. A good example of this occurred in 2013 when McDonald’s announced a stock buyback program. They purchased shares at an average price of $96.96. Their stock is currently trading at over $160 per share, meaning that shareholders have profited from the buyback program.
With that in mind, here are three ways that investors may benefit from stock buybacks:
- Their remaining shares generally increase in value – When a company issues a stock buyback their earnings per share increase, but a stock buyback generally has the effect of causing a company’s price per share to rise. This means that, while the shareholder may own fewer shares, the shares they continue to own should increase in value.
- They own a bigger share of the company – Because there are fewer outstanding shares, and each share represents a piece of ownership in the company, each investor’s remaining shares give them a larger ownership stake in the company.
- They can realize a tax advantage – Stock buybacks are taxed differently from dividends – Stock buybacks and dividends are taxed at different rates. Dividends are taxed at the ordinary tax rate for the individual. In contrast, buybacks are taxed at a lower capital gains tax rate. Furthermore, investors can defer capital gains if share prices increase.
Why Does a Company Buyback Its Own Stock?
Unused cash can be a drag on a company’s balance sheet. For that reason, a company may choose to repurchase its shares for a variety of reasons:
- It considers it to be the best use of capital at that time – it’s an expensive proposition for a company to have a large amount of excess cash sitting on the sidelines. On occasion, a company will choose to use excess cash to reinvest in its business or even to participate in arbitrage (growth through acquisition). However in recent years, it’s become widely accepted for a company to announce a share buyback as a way of liquidating some excess capital.
- To increase the price of its shares from what is perceived to be an unfair valuation – traders frequently trade on the news. Sometimes when a company goes through a few rough news cycles, their stock can experience a sharp selloff. At times like this, a stock buyback can be seen as a company betting on itself because a company’s stock price will tend to rise upon the announcement that it is participating in a share repurchase.
- Improve company metrics – as mentioned above, a stock buyback has some predictable effects on a company’s bottom line by increasing its earnings per share and decreasing the book value per share. However, when a company announces a buyback investors, particularly traders, view this as a sign that the company is healthy and will “bid up” the stock. This can elevate the stock’s valuation, raise its price-to-earnings-ratio (P/E ratio) and see its return on equity (ROE) increase.
- Overcome the effect of dilution from employee stock options – as a way of attracting top talent, many companies make stock options an integral part of a compensation package. When these options are exercised, it increases the number of outstanding shares in the market, which can have negative effects on a company’s balance sheet. Stock buybacks are a way to mitigate those effects.
Which is Better a Share Buyback Program or a Dividend?
The fact is that there are some companies that do both. Apple, Microsoft, and Cisco Systems are three examples of companies that pair dividends with stock buybacks. However, these are blue-chip companies that have large market capitalizations. Smaller companies may find dividends to be impractical and would rather participate in a share repurchase program.
Both a stock buyback and issuing a dividend are ways of returning capital to shareholders. Dividends are issued out of a company’s residual earnings either quarterly, semi-annually, or annually. A dividend does not directly affect a company’s market capitalization, although companies that issue dividends may see a short-term increase in its stock price as income-oriented investors try to capture the dividend.
By contrast, stock buybacks reduce the number of the company’s outstanding shares which will directly affect its market capitalization. Although a company can see the value of its stock increase with the declaration of a stock buyback, its market cap will go down. However, its earnings per share will increase, which can be an indirect motivation for companies to announce a buyback to begin with.
What Are the Criticisms of Stock Buybacks?
Stock buybacks were once considered illegal, but the practice became legal during the 1980s. But it has only been in the 15 years or so that stock buybacks have become standard operating procedure for many companies – even some of the most venerable blue chip companies. Still, stock buybacks are still criticized for several reasons:
One critique of a stock buyback is that a company can use excess cash for a variety of purposes that contribute to its social purpose. These can include raising wages for existing workers, investing in research and development, or increasing capital expenditures.
The idea that a company might be beholden to its employees as much as, or at least in proportion to, its shareholders, is more of a philosophical debate. A more fundamental concern is that stock buybacks may be too short-sighted. By putting too much emphasis on the next quarter, or the next six months, a company may be undervaluing its cash on hand and issuing stock buybacks that are too large, which can hurt shareholders and even the broader economy.
A third concern that economists have about stock buybacks is that, because repurchasing stock can have positive effects on a company’s balance sheet, a company may use a buyback as a way of covering up more serious issues. For example, it’s a fairly common practice for companies to borrow money to execute its share buybacks. But if that borrowed money is taking the place of actual cash, it can reflect that a company is using a buyback to paper over deeper problems.
The Bottom Line on Stock Buybacks
When a company issues a stock buyback program, it will have some immediate effects on its bottom line, most notably its earnings per share will increase and its book value per share will decrease. Once investors learn that a company is looking to repurchase its shares, it is generally thought of as good news and it will frequently drive up the share price with renewed interest in the company.
Companies initiate stock buybacks for a number of reasons, most commonly because it sees it as being the best use of cash as opposed to research and development or making other capital investments. In some cases, a company will buy back its shares to intentionally drive up the price of their stock if it feels it is undervalued in the market.
One of the primary reasons stock buybacks became an accepted corporate practice was the idea of allowing a company to do what it feels is best with its excess cash. However, there are still critics of the practice. Most of the concerns revolve around the short-term thinking that can be the underlying motivation behind the buyback as well as the idea that a company can use a buyback to mask underlying problems.