What Is a Stock Buyback? Definition & Effects
Stock buybacks are usually viewed as a positive signal by the market.
What Is a Stock Buyback?
When a publicly traded company repurchases outstanding shares of its own stock on the open market (or directly from existing shareholders), this is known as a stock buyback. When a stock buyback occurs, two things happen immediately—the number of shares outstanding decreases, and the proportion of the company each share represents increases.
In other words, after a buyback occurs, existing shareholders (assuming they didn’t sell any of their own shares back to the company) suddenly have an increased stake in the business, both in terms of their percentage ownership and the weight of their voting rights. A stock buyback is often described as a company “investing in itself.”
Why Do Companies Repurchase Shares?
Generally, companies repurchase shares when they have “extra” cash on hand that is not already slated for other investments or operations. This is usually done for two reasons—to increase share value for investors and to reduce share dilution.
To Increase Share Price
Because price is a product of supply and demand, reducing the supply of shares on the market should increase demand, which should, in turn, increase share price, thus delivering additional value to existing shareholders.
Because buybacks are known to increase share price, just the announcement of an upcoming buyback often drives shares up in price as investors scramble to buy in before the buyback.
To Combat Share Dilution
When a company’s employees exercise their stock options, more shares enter the market, causing each existing share to represent a smaller stake in the company. This effect is known as share dilution. Buybacks combat share dilution by removing shares from the market, which results in each remaining share representing a larger stake in the company.
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What Are the Effects of a Stock Buyback?
Stock buybacks have a multitude of effects across several areas. They affect shares, shareholders, financial ratios, and the company itself.
On Stock Price
As mentioned above, stock buybacks should—in theory—drive stock price up for several reasons. First, if demand for shares remains the same, but fewer shares are available, shares should trade at higher prices due to their relative scarcity.
Second, since buybacks require valuable cash, companies usually conduct them when they aren’t in desperate need of funds to pay off debt or finance important operations. For this reason, a buyback can be seen as a sign of financial health and stability, which can make a stock more appealing to investors, further driving its price up.
On Financial Ratios
- Return on Assets (ROA): Stock buybacks require cash, which is an asset. Since buybacks reduce cash, assets (the denominator in the ROA calculation) are reduced, resulting in a higher return on assets figure, which is typically viewed as a positive by the market.
- Return on Equity (ROE): Because buybacks reduce the number of shares outstanding, a company’s equity (AKA book value, the denominator in the ROE calculation) decreases, resulting in a higher return on equity figure, which is typically viewed as a positive by the market.
- Earnings per Share (EPS): Reducing the number of shares outstanding also boosts earnings per share, as the same earnings are divided among fewer shares. The higher a company’s earnings, the more attractive its stock.
- Price-to Earnings (P/E): Since buybacks increase EPS (the denominator in the P/E calculation), they decrease a company’s price-to-earnings ratio. The lower a company’s P/E ratio is compared to its competitors, the more attractive it typically is to value investors.
On Shareholders
Since buybacks reduce the number of shares a company has in circulation, each remaining share represents a larger stake (and more voting rights) in the company. This is a plut for shareholders, as the more of a company they own, the more upside they will see if the company increases in value. Additionally, each share will have a larger impact in terms of its holders voting rights when it comes to decisions that could affect a company’s future success.
Further, since buybacks typically drive share price up, existing shareholders stand to benefit from these repurchases in the form of capital gains.
On the Company
When a company conducts a buyback, it spends cash that could have been used for any number of other purposes, including paying down debt, hiring, research and development, or the acquisition of new plants, property, or equipment. In other words, its assets decrease.
However, buybacks can also stir up publicity, instill public confidence in a company, and cause its stock to rise in value, which can help it secure additional financing and new investors.
