There are several ways in which a company can return wealth to its shareholders. Although stock price appreciation and dividends are the two most common ways, there are other ways for companies to share their wealth with investors. In this article, we will look at one of those overlooked methods: share buybacks. We'll go through the mechanics of a share buyback and what it means for investors.

What Is a Stock Buyback? 

A stock buyback, also known as a share repurchase, occurs when a company buys back its shares from the marketplace with its accumulated cash. A stock buyback is a way for a company to re-invest in itself. The repurchased shares are absorbed by the company, and the number of outstanding shares on the market is reduced. Because there are fewer shares on the market, the relative ownership stake of each investor increases.

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How Does a "Buyback" Work?

There are two ways that companies conduct a buyback: a tender offer or through the open market.

1. Tender Offer

The company shareholders receive a tender offer that requests them to submit, or tender, a portion or all of their shares within a certain time frame. The offer will state the number of shares the company wants to repurchase and a price range for the shares. Investors who accept the offer will state how many shares they want to tender along with the price they are willing to accept. Once the company has received all of the offers, it will find the right mix to buy the shares at the lowest cost.

The market typically perceives a buyback as a positive indicator for a company, and the share price often shoots up following a buyback.

2. Open Market

A company can also buy its shares on the open market at the market price. It is often the case, however, that the announcement of a buyback causes the share price to shoot up because the market perceives it as a positive signal.

Key Takeaways

  • A stock buyback occurs when a company buys back its shares from the marketplace.
  • The effect of a buyback is to reduce the number of outstanding shares on the market, which increases the ownership stake of the stakeholders.
  • A company might buyback shares because it believes the market has discounted its shares too steeply, to invest in itself, or to improve its financial ratios.

The Motives

Why do companies buy back shares? A firm's management is likely to say that a buyback is the best use of capital at that particular time. After all, the goal of a firm's management is to maximize return for shareholders, and a buyback typically increases shareholder value. The prototypical line in a buyback press release is "we don't see any better investment than in ourselves." Although this can sometimes be the case, this statement is not always true.

There are other sound motives that drive companies to repurchase shares. For example, management may feel the market has discounted its share price too steeply. A stock price can be pummeled by the market for many reasons such as weaker-than-expected earnings results, an accounting scandal, or just a poor overall economic climate. Thus, when a company spends millions of dollars buying up its own shares, it can be a sign that management believes that the market has gone too far in discounting the shares—a positive sign.

Improving Financial Ratios

Another reason a company might pursue a buyback is solely to improve its financial ratios—the metrics used by investors to analyze a company's value. This motivation is questionable. If reducing the number of shares is a stratgy to make the financial ratios look better and not to create more value for shareholders, there could be a problem with management. However, if a company's motive for initiating a buyback is sound, better financial ratios as a result could simply be a byproduct of a good corporate decision. Let's look at how this happens.

First, share buybacks reduce the number of shares outstanding. Once a company purchases its shares, it often cancels them or keeps them as treasury shares and reduces the number of shares outstanding in the process.

Moreover, buybacks reduce the assets on the balance sheet, in this case, cash. As a result, return on assets (ROA) increases because assets are reduced; return on equity (ROE) increases because there is less outstanding equity. In general, the market views higher ROA and ROE as positives.

Suppose a company repurchases one million shares at $15 per share for a total cash outlay of $15 million. Below are the components of the ROA and earnings per share (EPS) calculations and how they change as a result of the buyback.

As you can see, the company's cash hoard has been reduced from $20 million to $5 million. Because cash is an asset, this will lower the total assets of the company from $50 million to $35 million. This increases ROA, even though earnings have not changed. Prior to the buyback, the company's ROA was 4% ($2 million/$50 million). After the repurchase, ROA increases to 5.71% ($2 million/$35 million). A similar effect can be seen for EPS, which increases from 20 cents ($2 million/10 million shares) to 22 cents ($2 million/9 million shares).

The buyback also improves the company's price-earnings ratio (P/E). The P/E ratio is one of the most well-known and often-used measures of value. At the risk of oversimplification, the market often thinks a lower P/E ratio is better. Therefore, if we assume that the shares remain at $15, the P/E ratio before the buyback is 75 ($15/20 cents). After the buyback, the P/E decreases to 68 ($15/22 cents) due to the reduction in outstanding shares. In other words, fewer shares + same earnings = higher EPS, which leads to a better P/E.

Based on the P/E ratio as a measure of value, the company is now less expensive per dollar of earnings than it was prior to the repurchase despite the fact there was no change in earnings.

Fast Fact

A buyback will always increase the stock’s value and benefit the shareholders in the short term.

Dilution

Another reason that a company may move forward with a buyback is to reduce the dilution that is often caused by generous employee stock option plans (ESOP).

Bull markets and strong economies often create a very competitive labor market. Companies have to compete to retain personnel, and ESOPs comprise many compensation packages. Stock options have the opposite effect of share repurchases as they increase the number of shares outstanding when the options are exercised. As in the above example, a change in the number of outstanding shares can affect key financial measures such as EPS and P/E. In the case of dilution, a change in the number of outstanding shares has the opposite effect of repurchase: it weakens the financial appearance of the company.

If we assume that the shares in the company had increased by one million, the EPS would have fallen to 18 cents per share from 20 cents per share. After years of lucrative stock option programs, a company may decide to repurchase shares to avoid or eliminate excessive dilution.

Tax Benefit 

In many ways, a buyback is similar to a dividend because the company is distributing money to shareholders albeit in an alternative way. Traditionally, a major advantage that buybacks had over dividends was that they were taxed at the lower capital-gains tax rate. Dividends, on the other hand, are taxed at ordinary income tax rates when received. Tax rates and their effects typically change annually; thus, investors consider the annual tax rate on capital gains versus dividends as ordinary income when looking at the benefits.

The Bottom Line 

Are share buybacks good or bad? As is so often the case in finance, the question may not have a definitive answer. Buybacks reduce the number of shares outstanding and a company’s total assets, which can affect the company and its investors in many different ways. When looking at key ratios such as earnings per share and P/E, a share decrease boosts EPS and lowers the P/E for more attractive value. Ratios, such as ROA and ROE, improve because the denominator decreases creating increased return.

In the public market, a buyback will always increase the stock’s value to the benefit of shareholders. However, investors should ask whether a company is merely using buybacks to prop up ratios, provide short-term relief to an ailing stock price, or to get out from under excessive dilution. For related reading, see "4 Reasons Investors Like Buybacks")