There are many different factors that can influence stock prices. Some of them might be due to the actions of the operating company itself. Stock buybacks are one of the two main ways in which a business can return money back to its shareholders. In the following, we are going to dive further into stock buybacks, including the question of how stock buybacks actually work.
What Is a Stock Buyback?
When a company decides to directly return profits to its investors, it may do so by paying out dividends to the owners, or by repurchasing shares of its own stock (or a mixture of both). Simply put, a stock buyback is the action of buying back shares as a company of its own stock from the marketplace.
As soon as a certain amount of shares gets repurchased by the company, the total number of outstanding shares decreases. The proportional ownership value of each share will rise in accordance with the decrease of available shares. Therefore, the value of each share of stock also increases, leading to a stock price increase, which usually brings positive reactions to most shareholders.
Stock repurchases don’t only increase shareholder value but are also a relatively easy way for companies to reinvest their cash back into the business. That being said, there may be some flaws and scenarios, where share buybacks may not necessarily be the best option for the business and its shareholders.
How do Stock Buybacks Work?
In general, there are two main ways of how a company can perform a stock buyback. The most common way for a business to buy back shares is through the open market. Just like ordinary investors, companies simply buy shares of stock through a broker from the open market. However, because market prices tend to fluctuate in accordance to supply and demand principles, companies would drive up the stock price too much as a result of a sudden increase in demand. To prevent this from happening, companies are limited by the number of shares that they can buy from the market.
Another way for companies to buy back stock is by conducting a tender offer, which is essentially a request for investors to voluntarily sell their amount of shares to the company based on a specific price range that is determined by the company. The company will then eventually buy the shares of all investors that accepted the offer if they fall into an attractive price point for the business.
Why Stock Buybacks?
A business may have multiple reasons to perform any share buyback programs. We will discuss some of the main points that would cause a company to buy back its stock.
Stock Buybacks Make a Company Look Better
Let’s assume that there are 10,000 shares of stock by Company ABC outstanding. Suppose that the management of the company decides to buy back 1000 shares of the market. Quite simply, this action would effectively reduce the total amount of shares outstanding to 9500.
The decrease in the number of shares would consequently mean that the financial ratios of each share become more enhanced. For instance, earnings per share (EPS) will increase, not because the earnings of the business rise, but because each share of stock will hold more earnings, as the total amount of stock is lower than before.
In other words, the earnings per share, one of the most important financial metrics for investors, which also is one of the main factor for stock price changes, automatically increases with each stock buyback, despite the fact that the underlying business itself doesn’t necessarily have to grow. The same principle applies to the dividend yield, p/e ratio, and other financial metrics. This leads investors to become more encouraged to buy and thus drive up the stock price to a higher level.
Buybacks Are Oftentimes the Easier Option to Raise Shareholder Value
This concludes that a company doesn’t necessarily have to grow to increase its value to the investors. As mentioned in the beginning, paying out dividends would be the alternative option for companies to return profits back to their shareholders. However, dividends are oftentimes more difficult to sustain, as the expectations of consistent dividends payments can be some sort of pressure to the company. In general, sudden dividend cuts often lead to more heavy stock fall downs than any modification to stock buyback programs. Therefore, share repurchases can oftentimes be the easier avenue for businesses.
Moreover, when companies don’t see an effective opportunity to reinvest their earnings otherwise, they might just consider buying back some shares, as it is a more simple way to reduce capital costs in the future and return some cash back to the company’s shareholders.
When the Stock Is Undervalued
The management of a company may become encouraged to buy back shares when a stock price falls into an undervalued level. Established financial metrics such as a low price-to-earnings ratio or the price-to-book ratio can indicate the undervaluation of a stock. Therefore, in times when a company’s stock price gets hit because of different reasons such as negative market sentiment, short term incidents, or sudden earnings drops that don’t reach investors expectations, companies may have a good opportunity to benefit from the low stock price by buying back its shares from the market.
As soon as the stock price recovers, the company may have the choice of issuing the same amount of shares, which were taken out of circulation earlier, to ultimately make a profit from the undervaluation of the stock.
The Impact of Stock Buybacks
The most obvious impact that stock repurchases will have on a stock is, as mentioned above, the increase of the per-share measures such as earnings-per-share and cash flow per share (CFPS) because of the reduction of shares outstanding as a result of each stock buyback. This also means that stock buybacks are a relatively simple way for companies to boost shareholder value without actually growing the business from operations.
Of course, the increase in profitability of each share will be recognized by investors and an increase in the stock price will usually follow, as long as the P/E level of a company remains the same.
Stock buybacks can be a great alternative way to dividends, for the company to return money back to its shareholders by decreasing the number of shares outstanding and increasing the per-share measures for each share. Especially long-term investors can substantially build their wealth from frequent stock buybacks by the company.
That being said, share buybacks are certainly not always the best choice to make and companies may choose bad times and unfavorable price points to conduct share buyback programs. Many investors only regard stock buybacks as good when the company’s management is confident at being able to buy back shares at an undervalued price. Otherwise, purchasing overvalued shares would not be a good investment and rather hurts the business and its shareholders over the long term.