Stock Buybacks: Why Do Companies Buy Back Shares? (2024)

Astock buyback occurs when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously distributed among public and private investors.

When a company repurchases its shares, it can purchase the stock onthe open market or from its shareholders directly.In recent decades, share buybacks have overtaken dividends as a preferred way to return cash to shareholders. Though smaller companies may choose to exercise buybacks, blue-chip companies are much more likely to do so because of the costs involved.

Key Takeaways

  • Companies do buybacks for various reasons, including company consolidation, equity value increase, and looking more financially attractive.
  • The downside to buybacks is they are typically financed with debt, which can strain cash flow.
  • Stock buybacks can have a mildly positive effect on the economy overall.

Reasons for Stock Buybacks

Because companies raise equity capital through the sale of common and preferred shares, it may seem counter-intuitive that a business might choose to give that money back. However, there are several reasons why it may be beneficial for a companyto repurchase its shares, including reducing the cost of capital, ownership consolidation, preserving stock prices, undervaluation, and boosting its key financial ratios. In Canada, it is called a normal-course issuer bid (NCIB) when Canadian companies buy back their shares.

Stock Repurchases Reduce Costs

Each share of common stock represents a small stake in the ownership of the issuing company, including the right to vote on the company policy and financial decisions. If a business has a managing owner and one million shareholders, it actually has 1,000,001 owners. Companies issue shares to raise equity capital to fund expansion, but if there are no potential growth opportunities, holding on to all that unused equity funding means sharing ownership for no good reason.

Businesses that have expanded to dominate their industries, for example, may find that there is little more growth to be had. With so little headroom left to grow into, carrying large amounts of equity capital on the balance sheet becomes more of a burden than a blessing.

Many shareholders demand returns on their investments in the form of dividends, which is a cost of equity—so the business is essentially paying for the privilege of accessing funds it isn't using. Therefore, buying back some or all of the outstanding shares can be a simple way to pay off investors and reduce the overall cost of capital. For this reason, Walt Disney (DIS) reduced its number of outstanding shares in the market by buying back 73.8 million shares, collectively valued at $7.5 billion, in 2016.

Stock Buybacks Consolidate Ownership

Companies issue shares to raise funding for projects. Several types of shares can be issued, but the two most popular are common and preferred shares. Common—also called ordinary—shares come with voting privileges and ownership. Preferred shares differ in that dividends are paid out to the shareholders before common shareholders, and these shareholders are higher in the queue for payout during a bankruptcy proceeding.

A company with thousands of stocks issued essentially has thousands of voting owners. A buyback reduces the number of owners, voters, and claims to capital.

Stock Buybacks: Why Do Companies Buy Back Shares? (1)

Stock Buybacks Preserve the Stock Price

Shareholders usually want a steady stream of increasing dividends from the company. And one of the goals of company executives isto maximize shareholder wealth. However, company executives must balance appeasing shareholders withstaying nimble if the economy dips into a recession.

Why do some favor buybacks overdividends? If the economy slows or falls into recession, a company might be forcedto cutits dividends to preservecash. The result would undoubtedlylead toa sell-off in the stock. However, if the bank decidedto buy back fewer shares, achieving the same preservation of capital as adividend cut, the stock price would likely take less of a hit.

Committing to dividend payouts withsteadyincreases will undoubtedly drive a company'sstock higher, but the dividend strategycan be a double-edged sword. In the event of a recession, share buybacks can be decreased more easily than dividends, with afar less negative impact on the stock price.

The Stock Is Undervalued

Another major motive for businesses to do buybacks is that they genuinely feel as if their shares are undervalued. Undervaluation occurs for several reasons, often due to investors' inability to see past a business' short-term performance, sensationalist news items, or a general bearish sentiment. For example, a wave of stock buybacks swept the United States in 2010 and 2011 when the economy was recovering from the Great Recession.

Many companies began making optimistic forecasts for the coming years, but company stock prices still reflected the economic doldrums that plagued them in years prior. These companies invested in themselves by repurchasing shares, hoping to capitalize when share prices finally began to reflect new, improved economic realities.

If a stock is dramatically undervalued, the issuing company can repurchase some of its shares at this reduced price and then re-issue them once the market has corrected, thereby increasing its equity capital without issuing any additional shares. However, investors may be reluctant to purchase the re-issued shares if they feel they've been burned by a company this way.

A repurchase and reissue can be a risky move if prices stay low. However, it can enable businesses that have a long-term need for capital financing to increase their equity without further diluting company ownership.

See Also
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For example, assume a company issues 100,000 shares at $25 per share, raising $2.5 million in equity. An ill-timed news item questioning the company's leadership ethics causes panicked shareholders to begin to sell, driving the price down to $15 per share. The company decides to repurchase 50,000 shares at $15 per share for a total outlay of $750,000 and wait out the frenzy.

The business remains profitable and launches a new and exciting product line the following quarter, driving the price up past the original offering price to $35 per share. After regaining popularity, the company reissues the 50,000 shares at the new market price for a total capital influx of $1.75 million. Because of the brief undervaluation of its stock, the company was able to turn $2.5 million in equity into $3.5 million without further diluting ownership by issuing additional shares ($2.5 million - $750,000 = $1.75 million + $1.75 million = $3.5 million).

Stock Buybacks Adjust the Financial Statements

Buying back stock can also be an easy way to make a business look more attractive to investors. By reducing the number of outstanding shares, a company's earnings per share (EPS) ratio is automatically increased—because its annual earnings are now divided by a lower number of outstanding shares.

For example, a company that earns $10 million in a year with 100,000 outstanding shares has an EPS of $100. However, if it repurchases 10,000 of those shares, reducing its total outstanding shares to 90,000, its EPS increases to $111.11 without any actual increase in earnings.

Also, short-term investors often look to make quick money by investing in a company leading up to a scheduled buyback. The rapid influx of investors artificially inflates the stock's valuation and boosts the company's price-to-earnings ratio (P/E). The return on equity (ROE) ratio is anotherimportant financial metric that receives an automatic boost.

One interpretation of a buyback is that the company is financially healthy and no longer needs excess equity funding. The market can also view thatmanagement has enoughconfidence in the companyto reinvest in itself.

Share buybacks are generally seen as less risky than investing in research and development for new technology or acquiring a competitor; it's a profitable action as long as the company continues to grow. In addition, investors typically see share buybacks as a positive sign for appreciation in the future. As a result, share buybackscan lead to a rush of investors buying the stock.

Downside of Stock Buybacks

A stock buyback affects a company's credit rating if it borrows money to repurchase the shares. Many companies finance stock buybacks because the loan interest is tax-deductible. However, debt obligations drain cash reserves, which are frequently needed when economic winds shift against a company.

For this reason, credit reporting agencies view such-financed stock buybacks negatively: They do not see boosting EPS or capitalizing on undervalued shares as a justification for taking on debt. A downgrade in credit rating often follows such a maneuver.

Starting January 2023, stock buybacks by publicly-owned companies are subject to a 1% excise tax under specific conditions. The conditions that apply include:

  • The tax does not apply if the repurchases are less than $1 million.
  • New issues to the public or employees reduce the taxable amount of stocks repurchased.
  • If the repurchase is treated as a dividend, the tax does not apply.
  • Real estate investment trusts and regulated investment companies are exempt from the excise tax.
  • The tax is not deductible.

Stock Repurchase Effect on the Economy

Despite the above, buybacks can be good for a company. How about the economy as a whole? Stock buybacks can have a mildly positive effect on the economy overall. They tend to have a much more direct and positive impact on the financial markets, as they lead to rising stock prices.

But in many ways, the stock market feeds into the real economy and vice versa. For example, research has shown that increases in the stock market positively affect consumer confidence, consumption, and major purchases, a phenomenon dubbed "the wealth effect."

Another way improvements in the financial markets impact the real economy is through lower borrowing costs for corporations. In turn, these corporations are more likely to expand operations or spend on research and development. These activities lead to increased hiring and income, and fuel improvements in the household balance sheet. Additionally, they increase the chances that consumers can leverage up to borrow to buy a house or start a business.

Is a Share Buyback a Good Thing?

A share buyback is beneficial for a company if it has no reason to fund expansions or other projects or wants to influence its share price in the market. Repurchases may or may not benefit investors, depending on their goals and financial circumstances. However, if a company repurchases shares, then issues them later at a lower price, investors can buy them back at a lower price, generating a profit for themselves.

Who Benefits From a Stock Buyback?

It depends on the circumstances that led to the repurchase. The company generally benefits, but a repurchase can also pay off for investors if a business is struggling because they can reinvest the capital into a better performing company.

What Does a Stock Buyback Do?

A share repurchase takes outstanding shares off the market and returns capital to investors.

The Bottom Line

A company repurchases its shares when it wants to consolidate ownership, preserve stock prices, return stock prices to real value, boost financial ratios, or reduce the cost of capital.

Investors can benefit from stock buybacks because the practice has generally taken the place of dividends. However, there are business drawbacks for stock repurchases, such as possible taxes on the buybacks, a reduction in credit rating, or loss of investor confidence.

Stock Buybacks: Why Do Companies Buy Back Shares? (2024)

FAQs

Stock Buybacks: Why Do Companies Buy Back Shares? ›

Public companies use share buybacks to return profits to their investors. When a company buys back its own stock, it's reducing the number of shares outstanding and increasing the value of the remaining shares, which can be a good thing for shareholders.

Why do companies repurchase shares of their stock stock buybacks? ›

However, there are several reasons why it may be beneficial for a company to repurchase its shares, including reducing the cost of capital, ownership consolidation, preserving stock prices, undervaluation, and boosting its key financial ratios.

Why would a company do a share buy back? ›

Share buybacks enable companies to raise shareholder value. Under normal market conditions, the portion of profits a company uses to buy back shares should strengthen its share price. Imagine a listed company with 1,000 shares, and 100 (10%) of them are held by one shareholder.

Who benefits most from stock buybacks? ›

A buyback can benefit investors because they receive their capital back and are often paid a premium over the stock's market price. In addition, there is a boost in the share price for investors who still hold onto the stock; however, buybacks aren't necessarily always good for investors.

Is it good to buy shares during buyback? ›

The benefits of a buyback include an increase in earnings per share (EPS) since the same earnings are divided among fewer shares, potentially boosting the stock price. This can lead to higher returns for investors who hold onto their shares post buyback. A buyback can be in two types. Tender offer or open market offer.

Why does Warren Buffett like stock buybacks? ›

The big picture: As Buffett explains, the theory behind buybacks is that they reduce the number of shares outstanding, thereby giving each remaining shareholder ownership of a greater percentage of the company.

What are the disadvantages of stock buybacks? ›

Buybacks can also backfire for a company competing in a high-growth industry because they may be read as an admission that the company has few important new opportunities on which to otherwise spend its money. In such cases, long-term investors will respond to a buyback announcement by selling the company's shares.

Why are share buybacks bad for shareholders? ›

Downsides to a stock buyback

Here are a few of the most common reasons against buybacks: Buybacks can be used to cover up stock issuance to managers. If the company issues stock-based compensation to managers, it dilutes the ownership of shareholders.

Do shares fall after buyback? ›

What Happens to the Share Price After a Buyback? After a stock buyback, the share price of a company increases. This is so because the supply of shares has been reduced, which increases the price. This can be matched with static or increased demand for the shares, which also has an upward pressure on price.

Do companies pay tax on stock buybacks? ›

Buybacks trigger a firm-level excise tax liability, but dividends do not. Shareholders face individual-level taxes on dividends and realized capital gains, though a fraction of their equity is held in tax-preferred vehicles (e.g., retirement accounts) and is thus shielded from tax.

Why are the rich selling their stocks? ›

In mid-2023, news began to spread about the world's super-rich reducing their ownership of shares in public companies. The reason behind this move is to secure their wealth amidst rising interest rates and economic uncertainty. Similar issues are still ongoing to this day.

Why are stock buybacks worse than dividends? ›

If your company pays out a dividend, shareholders retain their shares and receive cash. If your company repurchases shares, the selling shareholders receive cash, and the remaining shareholders have shares with higher value (but they don't receive any cash).

Which companies do the most buybacks? ›

Biggest S&P 500 Buybacks
CompanySymbolYTD % ch.
Apple(AAPL)-9.1%
Alphabet(GOOGL)5.9%
RTX(RTX)11.0%
General Motors(GM)13.6%
6 more rows
Mar 19, 2024

What happens to stock prices after buyback? ›

The purpose of buyback or repurchase is to raise the company's stock price, which shareholders gain indirectly. By removing the number of shares from circulation, the value of the remaining shares will increase.

How to profit from buyback? ›

In order to profit on a buyback, investors should review the company's motives for initiating the buyback. If the company's management did it because they felt their stock was significantly undervalued, this is seen as a way to increase shareholder value, which is a positive signal for existing shareholders.

Can I sell my shares in buyback? ›

The required shares must be in the demat account before the offer ends. Do not sell shares after placing the order. Buyback orders cannot be modified. However, the client can delete or cancel the existing order and place a new one.

What are the pros and cons of stock buybacks? ›

Pros and cons of stock buybacks
Pros of Stock BuybacksPotential Drawbacks of Stock Buybacks
Can make earnings growth look stronger.Reduce available cash on a company's balance sheet.
Can offset dilution from stock-based compensation.Buybacks are now subject to a 1% excise tax.
3 more rows

What is a stock buyback and why is it controversial? ›

Buybacks can artificially inflate a stock's price and EPS even if a company's revenue or earnings performance is poor or weaker than expected. That's why some people view buybacks as a form of price manipulation that can easily misguide investors. Higher debt-to-equity ratio.

Why might a company repurchase its own stock on Quizlet? ›

Rationale: Companies may repurchase stocks to send a 'signal' to the market that the stock is undervalued. The company may also repurchase shares to keep the outstanding shares constant in order to reduce the dilutive effect on earnings per share that may occur when employees exercise stock options.

Why aren t stock buybacks illegal? ›

For most of the 20th century, stock buybacks were deemed illegal because they were thought to be a form of stock market manipulation. But since 1982, when they were essentially legalized by the SEC, buybacks have become perhaps the most popular financial engineering tool in the C-Suite tool shed.

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