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What Is a Buyback?
A buyback, also known as a share repurchase, occurs when a company purchases its own outstanding stock shares to reduce their number on the open market. This strategic move aims to enhance the value of remaining shares by decreasing supply. Companies often undertake buybacks to signal confidence in their financial stability and to counter the risk of a major shareholder gaining a controlling interest, which could lead to an unwanted takeover.
Key Takeaways
- Buyback Basics: A buyback, or share repurchase, occurs when a company buys its own shares, reducing the number of shares on the open market to boost the value of remaining shares.
- Motivations for Buybacks: Companies may initiate buybacks if they believe their shares are undervalued, to reward shareholders, or to prevent hostile takeovers.
- Economic Impact: Buybacks can enhance the stock’s earnings per share (EPS) and lower the price-to-earnings (P/E) ratio, potentially making the stock more attractive to investors.
- Criticism of Buybacks: Critics argue that buybacks may signal a lack of profitable growth opportunities and can deplete cash reserves, posing a risk during economic downturns.
- Regulatory and Tax Considerations: Recent legislation, like the Inflation Reduction Act of 2022, imposes a 1% excise tax on certain stock buybacks, affecting their financial attractiveness.
Investopedia / Yurle Villegas
How Stock Buybacks Work and Their Benefits
Buybacks are also known as share repurchases. They allow companies to invest in themselves. Cutting the number of shares on the market raises each investor’s ownership share.
A company might buy back shares if it thinks they’re undervalued and wants to boost investor returns. It increases the proportion of earnings that each share is worth. The stock price can increase if the price-to-earnings (P/E) ratio stays the same.
Fewer shares mean each one is worth a larger part of the company. The stock’s earnings per share (EPS) thus increases while the (P/E) ratio decreases, assuming the share price stays the same. Alternatively, investors may buy up the stock until the price increases and the (P/E) ratio matches its previous level.
A share buyback shows investors the business has enough cash for emergencies and is likely to face less economic trouble.
Buybacks as a Strategy for Employee Compensation
Companies often reward employees and executives with stock and options. A company can buy back shares and issue them to employees and management.
This strategy helps avoid the dilution of existing shareholders.
The practice is controversial. Congress attempted to address the issue with the Stock Buyback Reform and Worker Dividend Act of 2019 but the bill never made it past the Senate.
Economic Impact of Share Buybacks
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).
Exploring the Mechanics of the Buyback Process
Buybacks are carried out in two ways:
- Shareholders might be presented with a tender offer, which gives them the option to submit, or tender, all or a portion 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.
- A company may buy back shares on the open market over an extended time, sometimes using a schedule that purchases shares at certain times or regular intervals.
A company may fund its buyback by taking on debt, with cash on hand, or with its cash flow from operations.
Understanding Expanded Share Buyback Programs
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 to achieve a faster contraction of its share float.
The size of an expanded buyback affects its market impact. A big buyback often boosts the share price.
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.
Addressing Common Criticisms of Share Buybacks
Not all investors applaud a company’s stock buyback.
Some investors may see buybacks as a sign the company can’t find profitable new opportunities, troubling those seeking growth.
Buybacks can leave a business vulnerable if the economy falters or financial issues arise after using cash reserves.
Buybacks might be used to inflate share prices, potentially boosting 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
Expenditure on buybacks by S&P 500 companies in 2023. That’s a drop from the $922.7 billion companies spent in 2022.
Weighing the Pros and Cons of Share Buybacks
Advantages
Buybacks can attract new investors by boosting earnings per share (EPS) and lower the price-to-earnings (P/E) ratio, making shares seem more valuable if the price stays the same.
A buyback rewards shareholders by giving them money back. This is especially true for businesses that believe their shares are undervalued in the market.
Disadvantages
Buybacks involve spending capital. This may leave investors wondering why the company isn’t using its money to grow the business. It can leave the impression that the business isn’t making the best use of its 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 is underway.
Pros
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Share value may increase and attract new investors
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Puts money back into shareholders’ pockets
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May lead to increase in share price
Illustrative Example of a Share Buyback
A company’s stock price has underperformed its competitor’s stock even though it has had a solid year financially. To reward investors and provide a return to them, the company announces a share buyback program to repurchase 10% of its outstanding shares at the current market price.
The company had $1 million in earnings and one million outstanding shares before the buyback, equating to EPS of $1. Trading at a $20 per share stock price, its P/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 a Company Do a Buyback?
A buyback lets a company invest in itself, increasing the shares it holds.
A company may buy back shares if it believes they’re undervalued to reward investors. By repurchasing shares, it reduces available open market shares, making 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 a major shareholder from acquiring a controlling stake and launching a takeover bid.
How Is a Buyback Done?
Companies can offer shareholders a premium to buy back shares. The shareholders would have the option to submit all or some of their shares within a set time frame.
Alternatively, a company may create a share repurchase program and purchase shares on the open market at certain times or at regular intervals.
A company can fund its buyback by taking on debt, with cash on hand, or with the cash flow earned in its operations.
What Are Criticisms of Buybacks?
A buyback can create a perception that a business does not have other pathways for revenue growth.
It also can deplete the company’s cash reserves, leaving it less able to withstand a downturn.
Buybacks also are criticized for artificially inflating the share price.
The Bottom Line
Companies buy back their shares to reduce the number of shares outstanding. 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 pay in stock options.
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