What is a stock buyback?

Posted on Monday, September 24th, 2018 MarketBeat Staff

Every investor wants to receive a positive return on their investment. 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.

There are a number of ways a company can choose to return capital to its shareholders. Many companies engage in the practice of 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.

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 a standard operating procedure for many companies – even some of the most venerable blue-chip companies.

This article will review what a stock buyback is, the effects of stock buybacks for the company and the investor, the reasons why the companies engage in stock buybacks. As a deeper dive, you'll also get an overview of how stock buybacks differ from a company issuing dividends and criticisms of stock buybacks.

What is a stock buyback?

In a stock buyback, or share repurchase program, a company repurchases their 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. A company can execute a stock buyback in one of two ways:

  1. 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.
  2. Buyback 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.

The effects of a stock buyback for the company

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.

  1. Their 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.
  2. Their 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.
  3. 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.

The effects of a stock buyback for the investor

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. 

  1. 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.
  2. 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.
  3. 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 do company’s buyback their stock?

Unused cash can be a drag on a company’s balance sheet. For that reason, a company may choose to repurchase their shares for a variety of reasons:

  • They consider 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 their 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 their 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 they are 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 their 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 their price-to-earnings-ratio (P/E ratio) and see their 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.

Executing a stock buyback versus issuing a dividend

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 their stock price as investors try to take part in the dividend by purchasing stock before the ex-dividend date and because of the halo effect that can occur because a company that issues a dividend is seen to be a company that is doing well.

However, for all the reasons that investors like dividends, they also create a level of expectation. If you're an investor who is used to receiving a dividend and better still a dividend that consistently increases, then a company that may decide to not issue a dividend, or decreases the amount of the dividend could be seen as having financial trouble. This can lead to panicked selling as investors will look to shift their money to a company that is offering a dividend.

By contrast, stock buybacks reduce the number of the company’s outstanding shares which will directly affect their market capitalization. Although a company can see the value of their stock increase with the declaration of a stock buyback, their market cap will go down. However, their earnings per share will increase, which can be an indirect motivation for companies to announce a buyback, to begin with.

Apple, Microsoft, and Cisco Systems are three examples of companies that pair dividends with stock buybacks. These are blue chip companies that have large market capitalizations. However, smaller companies may find dividends to be impractical and would rather participate in a share repurchase program.

Criticism of stock buybacks

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 their 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 their 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

Prior to the early 1980s, companies were prohibited from repurchasing their own shares. Once those rules were relaxed, it became an accepted practice albeit one that was not used very frequently. However, since the year 2000, the practice has become much more accepted. There is even now an exchange-traded fund (ETF) that tracks the performance of companies that issue stock buybacks.

When a company issues a stock buyback program, it will have some immediate effects on its bottom line, most notably their earnings per share will increase and their book value per share will decrease. Once investors learn that a company is looking to repurchase their shares, it is generally thought of as good news and they 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 they see 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 their shares to intentionally drive up the price of their stock if they feel 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 they feel is best with their 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.

 


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