What Is a Buyback?
The term buyback refers to a strategy companies use to buy their outstanding shares. Buybacks are used toreducethe number of shares availableon the open market. Shares are canceled before share capital is reduced. Companies buy back shares for different reasons, such asto increase the value of remainingshares available by reducing the supply or toprevent othershareholders from taking a controlling stake.
Key Takeaways
- A buyback is when a corporation purchases its own shares in the stock market.
- A repurchase reduces the number of shares outstanding, thereby inflating (positive) earnings per share and, often, the value of the stock.
- A share repurchase can demonstrate to investors that the business has sufficient cash set aside for emergencies and a low probability of economic troubles.
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Understanding Buybacks
Buybacks are also known as share repurchases. They allow companies to invest in themselves. Reducing the number of shares outstanding on the marketincreases the proportion of shares owned by investors. A company may feel its shares are undervalued and do a buybackto provide investors with a return.
And because the company is bullish on its current operations, abuyback also boosts the proportionof earnings that a share is allocated. This will raise the stock price if the sameprice-to-earnings(P/E) ratio is maintained.
The share repurchase reduces the number of existing shares, making each worth a greater percentage of the corporation. The stock’s earnings per share (EPS)thus increases while the(P/E) ratio decreases or the stock price increases. A share repurchase demonstrates to investors that the business has sufficient cash set aside for emergencies and a low probability of economic troubles.
Another reason for a buyback is for compensation purposes. Companies often award their employees and management with stock rewards and stock options. To offerrewards and options, companies buy back shares and issue them to employees and management. This helps avoid the dilution of existing shareholders. However, buyback usage to increase executive compensation is a concern that Congress attempted to address with the Stock Buyback Reform and Worker Dividend Act of 2019 but it never made it past the Senate.
Because share buybacks are carried out using a firm's retained earnings, the net economic effect to investors would be the same as if those retained earnings were paid out as shareholder dividends (tax considerations aside).
Buyback Process
Buybacks are carried out in two ways:
- Shareholders might be presented with a tender offer, where they have the option to submit, or tender, all or aportion of their shares within a given time frame at a premium to the current market price. This premium compensates investors for tendering their shares rather than holding onto them.
- Companies buy back shares on the open market over an extended time and may even have an outlined share repurchase program that purchasesshares at certain times or at regular intervals.
A company can fund its buyback by taking on debt, with cash on hand, or with its cash flow from operations.
An expanded share buyback is an increase in a company’s existing share repurchase plan. An expanded share buyback accelerates a company’s share repurchase plan and leads to a faster contraction of its sharefloat. The market impact of an expanded share buyback depends on its magnitude. A large, expanded buyback is likely to cause the share price to rise.
The buyback ratio considers the buyback dollars spent over the past year, divided by its market capitalization at the beginning of the buyback period. The buyback ratio enables a comparison of the potential impact of repurchases across different companies. It is also a good indicator of a company’s ability to return value to its shareholders since companies that engage in regular buybacks have historically outperformed the broad market.
Criticism of Buybacks
A share buyback can give investors the impression that the corporation does not have other profitable opportunities for growth, which is an issue for growth investors looking for revenue and profit increases. A corporation is not obligated to repurchase shares due to changes in the marketplace or economy.
Repurchasing shares puts a business in a precarious situation if the economy takes a downturn or the corporation faces financial issues it cannot cover. Others allege that sometimes buybacks are used to inflate share price artificially in the market, which can also lead to higher executive bonuses.
As part of the Inflation Reduction Act of 2022, certain stock buybacks for domestic public companies will incur a 1% excise tax, making them more expensive for corporations. This applies to buybacks after Dec. 31, 2022.
$795.2 billion
Buybacks in 2023 among S&P 500 companies. That's a drop from the $922.7 billion companies spent in 2022.
Advantages and Disadvantages of Buybacks
Advantages
Companies can attract more investors after going through a share buyback. That's because buybacks often boost the stock's EPS, which reduces its P/E ratio. If the stock price stays the same, newer investors may believe the share price has a better value.
Completing a share buyback allows companies to reward shareholders by putting money back in their pockets. This is especially true for businesses that believe their shares are undervalued in the market.
Disadvantages
Buybacks involve spending capital to repurchase shares. But, this may leave investors wondering why companies aren't using their money to grow their business. This can give them the impression that businesses aren't making better use of their capital.
Companies should be cautious about doing buybacks because it can cause higher stock prices to drop. A price drop may indicate problems within the company—even if a buyback takes place.
Pros
Share value may increase and attract new investors
Puts money stckeback into shareholders' po
Cons
May appear to stifle growth and turn off investors
May lead to drop in share price
Example of a Buyback
A company's stock price has underperformed its competitor's stockeven though it has had a solidyear financially. To rewardinvestors and provide a return to them, the company announces ashare buyback program to repurchase 10% of its outstanding shares at the current market price.
The company had $1 million in earnings and 1 million outstandingshares before the buyback, equating to EPS of $1. Trading at a$20 per share stock price, itsP/E ratio is 20. With all else being equal, 100,000 shares would be repurchased and the new EPS would be $1.11 or $1 million in earnings spread out over 900,000 shares. To keep the same P/E ratio of 20,shares would need to trade up 11% to $22.22.
Why Would Companies Do Buybacks?
A buyback allows companies to invest in themselves. If a company feels that its shares are undervalued, then it may do a buyback to provide investors with a return.By repurchasing shares, it reduces available open market shares and makes each worth a greater percentage of the corporation. Companies with cash on hand can use buybacks for employees and management compensation purposes, using the shares for employee stock options, The buyback helps avoid the dilution of existing shareholders.Finally, a buyback can be a way to prevent other shareholders from taking a controlling stake and avert a takeover bid.
How Is a Buyback Done?
A company can make a tender offer, at a premium over the current market price, to shareholders where they have the option to submit all or a portion of their shares within a given time frame.
Alternatively, a company may have an outlined share repurchase program that purchases shares on the open market at certain times or at regular intervals over an extended time. A company can fund its buyback by taking on debt, with cash on hand, or with the cash flow from operations.
What Are Criticisms of Buybacks?
Criticisms of buybacks include creating a perception that a business does not have other pathways for revenue growth. Furthermore, if a company purchases back its share and the economy takes a downturn, this would negatively impact its financial standing. Buybacks are also often criticized for artificially inflating the share price, which can be used to justify higher executive bonuses.Critics also argue that the 1% excise tax on buybacks will have negative consequences on the financial world.
The Bottom Line
Companies buy back their shares to reduce the number of share outstanding, or those available on the open market. The expectation is that if the float or number of shares outstanding is reduced, this will have a positive effect on the stock price. A company may consider a share buyback program for any number of reasons. One of the more controversial of these is to reward company executives who often get a large proportion of their renumeration in stock options.
