Why do companies buy back shares? Pros, Cons & FAQ

I have been watching the markets for over 25 years and stock buybacks are controversial among investors. Some investors view them as waste, others see them as a great way to earn tax-advantaged returns. Both proponents and critics have valid points. But who is right?

In this article, I will walk you through the many aspects of share buybacks and also the positives and negatives.

The short answer as to why companies buy back shares is to reduce the number of outstanding stock shares in the market, which executed correctly is one of the most risk-free ways to create shareholder value. 

Like everything in the world, the markets are driven by supply and demand. When a company reduces the supply and the demand remains the same, the market will pay more.

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However, not all companies do it correctly.

What is a stock buyback?

Stock buybacks are when a company purchases its stock and then cancels it. This reduces the number of shares outstanding and makes the company’s market capitalization less for each stock price. Buybacks, in effect, “re-slice” profits into smaller slices and give more to investors.

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Stock buybacks are one of the four main ways that a company can make use of its cash. These include investing in operations, buying another company, and paying dividends to shareholders.

A “repurchase authorization” is usually issued by a company to authorize a stock purchase. This allows the company to specify the amount of stock it will buy and the percentage of stock that it may buy. Although the former is riskier, a company can either borrow or use its own cash to buy stock.

A company will usually buy stock from the public market just like a regular investor. It buys stock from anyone who wishes to sell it, and not just specific owners. The company does this to ensure fair treatment of all investors, as any investor can sell into it.

It is important to know that a company can’t buy back shares even if it has been authorized. This applies whether management changes their mind, assigns a priority, or when there is a crisis. Stock buybacks are only authorized by management and are done according to the company’s needs.

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Is share buyback a good thing?

When done consistently, buybacks are a good thing and can significantly increase investors’ returns. They are loved by shareholders and top executives who use them effectively.

Investors can reap the benefits of share buybacks in several ways.

  • Shareholders who wish to exit an investment can repurchase the return cash.
  • A buyback can help the company increase its earnings per share. A smaller earnings pie is worth a larger share of earnings.
  • Buybacks can increase the stock’s upside potential for shareholders who wish to stay owners by reducing its share count. Each share of a company worth $1 billion is worth more if it is divided in fewer ways.
  • They are more tax-efficient than dividends which are taxable for those who receive them.
  • The company’s management supports the stock price by repurchases and shows confidence in its business.

These are compelling reasons, even more so if a company is able to buy back stock over time if it has enough cash. A company can increase shareholder returns by increasing share count by as little as 2 to 3 percent per year. The company might even be able to take advantage of its form of dollar-cost averaging.

Buybacks aren’t always good, but they can be a good thing. Poor managers can destroy value and siphon it off to their own benefit.

Improving Financial Ratios

Buybacks of stock shares reduce the number of shares outstanding. Buybacks also increase the return on assets (ROA) because there is less outstanding equity. This in turn increases the return on equity (ROE). P/E ratio is one of the most well-known measures of value, often used by the market. Generally speaking, investors perceive the higher ROE and ROA as positives.

The buyback can also improve the company’s price-earnings ratio (P/E), which is often used in the market as a measure of a stock’s value. The company is now less expensive per dollar of earnings before the repurchase, despite no increase in earnings.

Buybacks Help the Financial Statement

Share buybacks are less risky than developing new products or services. Investors usually perceive stock buybacks as a positive sign for appreciation. However, short term investors often try to make fast profits by investing in companies leading up to buybacks.

Buybacks can also lead to a mad surge in buying the company’s stock, inflating the P/E ratio and a return on equity ratio, ROE ratio, among other financial metrics that receive an automatic boost. The market can also view it as a sign of management’s confidence in the company and its ability to reinvest as long as the company grows.

Unused Cash Is Expensive

Each share stock represents a small part in the ownership of the issuing company. Companies issue share to raise equity capital to fund expansion. 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.

There are downsides to stock buybacks

Stock buybacks have the potential to destroy as well as increase value, so those opposed to buybacks must also present compelling arguments about why they are bad.

Here are some of the top reasons to avoid buybacks.

  • To cover stock issuances to managers, buybacks may be used. Stock-based compensation is a way for shareholders to be diluted if the company issues stock-based rewards to managers. Buybacks are used by some management teams to hide how much issuance has an impact on the share count.
  • Managers could profit from buybacks to increase their own wealth at the expense of shareholders. Managers who have options that become worth more than a certain stock price and the ability to influence stock prices via repurchases may decide to temporarily increase the stock price to gain access to their options.
  • Sometimes buybacks are not done well. A management team buying the stock at any price rather than at a fair price could be a waste of shareholder capital. If a stock is only worth $90, but the management team buys it for $170 that is destroying value.
  • Buybacks could make it difficult for businesses to raise the funds they need in other areas such as research and development, or investment in new products.

These are valid reasons why buybacks might be harmful, but each one relies on incompetent or self-dealing managers to reduce the buyback’s effectiveness or make it more destructive.

Each reason speaks volumes about the managers more than the buyback. Buybacks can be a great investment if they are executed well by competent management teams. If you are interested in investing in stocks, it is important to examine executives and form an opinion about them.

Sometimes, critics will argue against buybacks, stating that the money could be used elsewhere, such as in operations. In certain circumstances, this argument may hold true.

Dilution of Shares

Stock options can have the opposite effect to share repurchases in that they increase the number of outstanding shares when exercised. Key financial measures like EPS or P/E can be affected by a change in outstanding shares, as in the previous example.

The buyback may reduce the dilution caused by generous employee stock option plans (ESOP) companies. An organization may decide to buyback or repurchase shares to avoid excessive dilution, as it weakens the financial appearance of the company. A change in the outstanding shares can affect key financial measures such as EPS and P-E, like that of a change of share prices.

Effect on the Economy

Stock buybacks can have a positive effect on the economy overall. Lower borrowing costs for corporations lead to increased hiring, research, and development activities. Buybacks can also boost consumer confidence, consumption, and major purchases, a phenomenon dubbed “the wealth effect” Research shows that stock market increases have an improving effect on consumer confidence and consumption and on larger purchases. These activities increase hiring and income for the country as a whole.

Who is right?

Stock buybacks can be good or bad depending on who is doing them, when, and why. If a company is repurchasing stock and neglecting other priorities, it’s almost certain to make a big mistake that will ultimately cost shareholders.

A competent CEO would not spend cash on buybacks even if he has invested in operations. This could be a good investment because the CEO is focused on putting capital (shareholder money) into attractive investments. It’s a sign that you can trust your investment’s future if the management team looks out for shareholders.

You need to look at the company and its circumstances in order to determine whether or not a buyback is a good investment.

  • It is why it conducts the repurchase.
  • Are the shares being bought back simply being vacated by management?
  • Do you think the buyback is a wise use of money?
  • Is management able to deliver strong returns?

These are just a few of the many fundamental questions you should answer. However, if your company decides to buyback shares, it is important to understand why and whether it is a good decision.

This may depend on understanding the wider context.

Bottom line

Repurchases can be controversial at times, but they are just one way for companies to invest their shareholders’ money. What is most important in determining whether a buyback is good for shareholders is its management’s ability to manage the money it has been given by the shareholders. Poor management teams can lead to financial ruin.

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