Have you ever woken up, looked at a stock you were considering investing in, and seen dramatic gains, only to find that a stock buyback was the catalyst that sent stock prices skyward overnight? It’s a common occurrence in corporate finance.
Overall, share buybacks are perceived as a positive among market participants, generally leading to gains in stock prices. So, after they happen, it’s common for beginner investors to dive in — but is that a good move?
What are stock buybacks and what do they mean for the stock, both in the short term and long term?
What Are Stock Buybacks?
Stock buybacks, often referred to as share buybacks or share repurchases, are repurchases of stock in the open market by the issuing company. That’s right, if Apple announces a share buyback, it means that the company plans on using some of its mounds of cash to buy its own stock back.
These transactions tend to lead to dramatic gains, because investors see a few obvious positives when a company buys its own shares back from stock market participants:
- Financial Stability. In order for a company to be able to buy its own stock on the open market, it has to have a pretty sturdy financial foundation. So, when investors see a share buyback, they see a company on solid footing.
- Management Is Confident. No management team of a publicly traded company is going to buy shares back if they see trouble in the future. Therefore, share buybacks act as a sign of confidence from the company’s management team.
The Buyback Process
When share buybacks happen, there are generally three steps to the process:
- The Company Announces the Stock Buyback. First, the company will generally issue a press release letting investors know that it plans on buying its own shares in the open market. In some cases, the company will announce the number of shares or the total amount of money that it plans on allocating to the share buyback program; in others, the company will simply announce that it will be repurchasing shares at the open market price.
- The Company Repurchases Shares at Opportune Times in the Open Market. Following the announcement, the company will wait for the best time to execute share repurchases with the goal of purchasing the shares at the lowest price possible. The company purchases shares over a course of several transactions at different stock prices, depending on the state of the market at the time of the transaction.
- The Company Announces the Completion of the Share Buyback Program. Once the company has completed all of its share repurchases, it will either issue a press release or file a document with the U.S. Securities and Exchange Commission (SEC) explaining that it has completed the share repurchase program. In the document, the company provides information as to the number of shares it repurchased, the average price the company paid to repurchase the shares in the open market, and how many outstanding shares remain following the share buyback program.
Do I Have to Sell My Shares Back?
If you own shares of a company that announces a buyback, you don’t have to do anything, and you’ll retain shares that you already own. During a share repurchase program, the company will purchase shares from sellers in the open market, just like you would if you wanted to buy shares. After the company buys a block of shares, it simply absorbs them rather than putting them back on the market, reducing the total number of shares outstanding. Current shareholders have no obligation to sell their shares back to the company under a share buyback program.
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Why Would a Company Buy Its Own Shares?
When beginner investors hear of a share buyback, they often ask, “Why would a company want to buy its own shares back from investors?”
There are several reasons:
1. Management Believes the Stock Is Undervalued
One of the biggest reasons a company may decide to buy its shares back is because management holds the belief that the stock is trading below its fair market value. This is a common occurrence during economic recessions when the stock market falls into bear market territory.
The idea for the company is to buy shares back while stock prices are low and benefit from the upswing as the market recovers. Once the recovery takes place, the company is able to raise funds by selling the stock back in the open market at higher prices, benefitting from its willingness to bet on itself when market conditions were concerning.
However, share buybacks don’t just happen when bear markets take hold. Undervaluations happen in the stock market quite often, leading to an entire investing strategy known as value investing.
2. Share Repurchases Lead to Increased Investor Demand
Share buybacks also lead to increased interest among investors, largely because it makes the company look like it’s doing better on its balance sheet and other financial statements.
Many valuation metrics take the total number of outstanding shares into account. Some of the most important include:
- Earnings Per Share (EPS). When earnings are released, investors pay close attention to earnings per share. Analysts calculate this metric by dividing the total net income generated in the earnings period by the total amount of outstanding shares.
- Revenue Per Share. Revenue per share works in the same way as EPS. Many investors divide the total revenue by the total number of outstanding shares to get a better idea of the intrinsic value of publicly traded companies.
- Book Value Per Share. The book value per share metric gives investors a look at the company’s net asset value on a per share basis by dividing the company’s total net asset value by the total number of outstanding shares.
- Cash Per Share. Finally, investors look at the cash and cash equivalents as a lifeline for publicly traded companies. As such, the total amount of cash and cash equivalents on the company’s balance sheet is divided by the total number of outstanding shares to get a better understanding of the true value of the company.
Every one of these valuation metrics divides a financial metric by the number of outstanding shares. When a company repurchases shares, it reduces the number of outstanding shares on the open market, immediately increasing EPS, revenue per share, book value per share, and cash per share with each and every transaction because there are fewer shares to divide the financial data by.
3. Cash for Votes
Publicly traded companies sell shares of their stock in an attempt to raise funding. However, that cash is costly. Every share that’s sold gives away a slice of ownership in the overall company and bestows stockholders with voting power associated with their ownership stake.
When funding is raised through capital markets, the company’s management gives up some say in what’s going to happen in the future. Therefore, management teams often repurchase stock in an effort to regain control over the company. This is especially the case when the CEO, president, or chairperson of the company repurchasing shares is also its founder. In some cases, the company may even repurchase all outstanding shares, ultimately taking the company back into the private domain.
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How a Share Buyback Returns Shareholder Value
Share buybacks aren’t just a good thing for the companies that use their excess cash to take part in them; they’re also generally a great thing for investors. There are several reasons these transactions are good for investors, including:
1. Increased Investor Demand
As mentioned above, share buybacks lead to an improved balance sheet and valuation metrics. As a result, the stock becomes more attractive to the investing community.
That’s great news for current shareholders.
The stock market is a supply-and-demand dance. When share buybacks happen, the supply of remaining shares on the open market shrinks and valuation metrics improve. This generally leads to increased demand for the stock — and as the law of supply and demand tells us, when demand rises and supply shrinks, the stock price must increase.
Existing shareholders who held positions in the company prior to the buyback activity ultimately benefit from the gains in price caused by increased demand for the company’s stock.
2. Tax Benefits
When dividend payments are made, investors who have held the stock for less than one year have to claim the dividend income as earned income, paying the standard income tax rate. However, gains in the market value of stocks are not taxed until they’re sold. As long as an investment is held for a year or longer before you cash in, your gains will be taxed at the lower capital gains tax rate, rather than the standard income tax rate.
Therefore, when a company decides to return shareholder value through a share repurchase program rather than through dividend payments, they are ultimately handing down a reduction of the tax burden associated with the investment.
3. A Bigger Piece of the Pie
Think of a publicly traded company as your favorite pie at a Thanksgiving dinner. Every time someone new walks through the door, you know that your piece of your favorite pie after dinner is going to be smaller.
Publicly traded companies are figurative pies and the shares of stock that represent them are the pie slices. When there are more outstanding shares on the open market, the ownership percentage of the company represented by each share of stock is smaller.
Once a company has repurchased shares, there are fewer outstanding shares available for Wall Street participants, ultimately making each single share slightly more valuable.
Are There Any Downsides to Share Buybacks?
Share buybacks come with plenty of perks, both for publicly traded companies and for the investors who invest in them. However, even the most successful restaurant serves a bad dish once in a while.
In some cases, share buybacks aren’t exactly in the investors’ best interest.
Many companies decide to finance share buybacks with new loans rather than pay for them outright with cash on hand. The benefit to the company is simple — the interest on the loan is tax deductible, ultimately reducing its overall tax burden at the end of each quarter.
On the other hand, financed share buybacks are horrible for investors. High levels of debt are bad for investors because they become cash drains in the long-term. As a result, companies who use loans to repurchase shares often experience a reduction in their credit rating. In these cases, the share buybacks backfire and the reduced credit rating leads to declines.
All told, share buybacks are generally great for investors. They return value by handing each existing investor a larger slice of the pie, reducing exposure to taxes, and increasing demand for the stock through an improved balance sheet, ultimately leading to price appreciation.
However, the simple fact that a company has taken part in a share repurchase program shouldn’t be the basis for a decision to invest in that company. In some cases, these transactions can backfire, leading to reductions in the value of the company and the value of shares held by investors.
As always, the most profitable decisions in the stock market are educated ones. It’s important to do your research and get a real understanding of the risks and rewards associated with any investment before risking your hard-earned money.