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What Is A Stock Buyback?

Stock buybacks refer to the repurchasing of shares of stock by the company that issued them. A buyback occurs when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously distributed among public and private investors. With stock buybacks, also referred to as share buybacks, the company can buy the stock on the open market or buy it back from its shareholders directly. 

Why A Company Would Buy Back Its Own Shares

Since companies raise equity capital through the sale of common and preferred shares, it may seem counter-intuitive that a business might choose to give that money back. However, there are numerous reasons why it may be beneficial to a company to repurchase its shares, including ownership consolidation, undervaluation, and boosting financial ratios.

Unused Cash Is Costly 

Each share of common stock represents a small stake in the ownership of the issuing company, including the right to vote on company policy and financial decisions. If a business has a managing owner and one million shareholders, it actually has 1,000,001 owners. Companies issue shares to raise equity capital to fund expansion, but if there are no potential growth opportunities in sight, holding on to all that unused equity funding means sharing ownership for no good reason.

Shareholders demand returns on their investments in the form of dividends which is a cost of equity – so the business is essentially paying for the privilege of accessing funds it isn't using. Buying back some or all of the outstanding shares can be a simple way to pay off investors and reduce the overall cost of capital. For this reason, Walt Disney (DIS) reduced its number of outstanding shares in the market by buying back 73.8 million shares valued at $7.5 billion back in 2016.

Share Repurchase Plans Can Be Easily Changed

Ideally, shareholders want a steady stream of increasing dividends from the company. And one of the goals of company executives is to maximize shareholder wealth. However, company executives must balance appeasing shareholders with staying nimble if the economy dips into a recession. 

One of the hardest hit banks during the Great Recession was Bank of America Corporation (BAC). The bank has recovered nicely since then, but still has some work to do in getting back to its former glory. However, as of the end of 2017 Bank of America had bought back 509 million shares over the prior 12-month period and the bank plans to return over $17 billion to shareholders through share repurchases in 2018. Although the dividend has increased over the same period, the bank's executive management has consistently allocated more cash to share repurchases rather than dividends.  

Why are buybacks favored over dividends? If the economy slows or dips into recession, the bank might be forced to cut its dividend to preserve cash. The result would undoubtedly lead to a sell-off in the stock. However, if the bank decided to buy back fewer shares, achieving the same preservation of capital as a dividend cut, the stock price would likely take less of a hit. Committing to dividend payouts with steady increases will certainly drive a company's stock higher, but the dividend strategy can be a double-edged sword for a company. In the event of a recession, share buybacks can be decreased more easily than dividends with a far less negative impact on the stock price. This is why companies like Bank of America favor buybacks versus dividends when it comes to boosting shareholder wealth. 

The Stock Is Undervalued

Another major reason why businesses repurchase their own shares is to take advantage of undervaluation. Stock can be undervalued for a number of reasons, often due to investors' inability to see past a business' short-term performance or sensationalist news items. If a stock is dramatically undervalued, the issuing company can repurchase some of its shares at this reduced price and then re-issue them once the market has corrected, thereby increasing its equity capital without issuing any additional shares.

For example, let's assume a company issues 100,000 shares at $25 per share, raising $2.5 million in equity. An ill-timed news item questioning the company's leadership ethics causes panicked shareholders begin to sell, driving the price down to $15 per share. The company decides to repurchase 50,000 shares at $15 per share for a total outlay of $750,000 and wait out the frenzy. The business remains profitable and launches a new and exciting product line the following quarter, driving the price up past the issuing price to $35 per share. After regaining its popularity, the company reissues the 50,000 shares at the new market price for a total capital influx of $1.75 million. Because of the brief undervaluation of its stock, the company was able to turn $2.5 million in equity into $3.5 million without further diluting ownership by issuing additional shares.

Improve Financial Ratios & Boost Confidence

Buying back stock can also be an easy way to make a business look more attractive to investors. By reducing the number of outstanding shares, a company's earnings per share (EPS) ratio is automatically increased. Also, short-term investors often look to make quick money by investing in a company leading up to a scheduled buyback. The rapid influx of investors artificially inflates the stock's valuation and boosts the company's price to earnings ratio (P/E).

If a company is buying back shares, it can also be viewed by the market that management has enough confidence in the company to reinvest in itself. Investors typically see share buybacks as a positive sign that growth is likely to increase in the future. As a result, share buybacks can lead to a rush of investors buying the stock.   

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