When a stock buyback is announced, it means the issuing company intends to repurchase some or all of the outstanding shares originally issued to raise capital. In exchange for giving up ownership in the company and periodic dividends, shareholders are paid the fair market value of the stock at the time of the buyback.

A company may choose to buy back outstanding shares for a number of reasons. Repurchasing outstanding shares can help a business reduce its cost of capital, benefit from temporary undervaluation of the stock, consolidate ownership, inflate important financial metrics or free up profits to pay executive bonuses.

Key Takeaways

  • Companies sometimes buy back some of their own shares outstanding the market, effectively reducing its float.
  • A company may do so for a variety of reasons, including replacing equity financing for more cost-effective debt financing.
  • Companies may also use buybacks to profit off of undervalued shares or consolidate equity ownership.

Reduce Equity Financing Cost

The most generous interpretation of a company buyback is that the business is doing quite well financially and no longer has need of so much equity funding. Instead of carrying the burden of unneeded equity and the dividend payments it requires, the company refunds shareholders' investment, reducing its average cost of capital. However, the purpose of debt and equity capital is to fund growth.

So when a company voluntarily returns its equity capital, it may be an indication it has no viable expansion projects in which to invest. Blue-chip companies that have already come to dominate their industries may buy back shares because there is little room left for growth, rendering large capital reserves unnecessary.

Capitalize on Undervalued Shares

A company buyback does not always signify the issuing company has run out of uses for equity funding. In fact, it can also be used as a strategic device aimed at generating more equity capital without issuing any additional shares. If the company feels its stock is undervalued, it can choose to repurchase some or all of the outstanding shares at the deflated price and wait for the market to correct. Once the stock price moves back up, the company can reissue the same number of shares at the new higher price, increasing total equity capital while keeping the number of outstanding shares stable.

Consolidate Ownership

Stock buybacks are also used as a means of consolidating ownership. Each share of stock represents a small ownership stake in a company. The fewer outstanding shares, the fewer people the business has to answer to. Having fewer outstanding shares is also a simple way to inflate several important financial metrics used by analysts and investors to assess a business' value and growth potential. The earnings per share (EPS) ratio is automatically increased as its denominator is reduced. Similarly, the return on equity (ROE) figure gets a leg up if shareholder equity is minimized while profits remain stable.

While it may be understandable that a company would want to concentrate control of the business into the hands of its core leadership, the truth is that buybacks are increasingly utilized as a way to boost executive compensation. Shareholder dividends are paid out of a company's net profit. If there are fewer shareholders, the proverbial pie is divided into fewer pieces. In addition, many corporate bonus programs are predicated on the business attaining certain financial goals. Common benchmarks include increased EPS and ROE ratios, as mentioned above. Repurchasing outstanding shares enables businesses to increase executive compensation by making the company look more profitable.