RV Blog What is a Stock Buyback?

What is a Stock Buyback?

What is a Stock Buyback?

A stock buyback, also known as a share buyback or share repurchase program, is when a company seeks to purchase some of its stock from existing shareholders on the open market. When this happens, the company becomes an active buyer like any other investor looking to purchase a particular stock. The company will use its own revenue to purchase the stocks instead of investing this money back into the company or paying dividends to shareholders.

The point of a stock buyback program is to increase the price of the company’s stock on the open market. The price of the stock is determined by demand. When investors are interested in buying the stock, the price goes up. When investors want to sell their stock, it’s usually a sign the company is overvalued and/or headed for financial trouble, and the stock price will decline as a result. When the company decides to buy back some of its shares, it increases demand for the stock, and the price per share will rise.

Most U.S. companies are focused on increasing shareholder value. This can be accomplished in several ways. The company can invest in its operations and expand its business. If the company is seen as a success and brings in more profits, the stock price will go up. But the easiest way to increase shareholder value is to pay dividends directly to shareholders. This makes the stock more attractive to investors, which increases demand.

Finally, the company can buy back its own stock on the open market to artificially increase demand. As the price of the stock increases, so does the net worth of all shareholders.

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How Does a Stock Buyback Work?

A stock buyback needs approval from the company’s board of directors. The company will go over the pros and cons of buying the company’s stock on the market. If the board decides to move forward, the company will announce that it has received “repurchase authorization.” The announcement details how much money the company will devote to the repurchase program and/or how many shares the company wants to purchase from private stockholders.

The company will then purchase shares on the secondary market from any existing shareholder at the current stock price. Shareholders are not obligated to sell their stock back to the company, and any existing shareholder is welcome to participate. The buyback program also doesn’t target any specific type of investor or shareholder. Rather, it is an open invitation to anyone who currently owns the company’s stock.

The price per share of the company’s stock will then increase as demand for the stock increases. Other investors may also decide to purchase the stock with the goal of selling it back to the company, further increasing demand and the price per share.

Is a Stock Buyback Good for Investors?

A stock buyback program is almost always good for investors because it increases the price per share of the company’s stock, which increases the net worth of all shareholders. Anyone who owns the company’s stock while the buyback program is in effect will see the value of their shares increase.

The company will buy back its own stock in an effort to maximize shareholder value. Corporate America adheres to the principle that companies should increase returns for shareholders as much as possible. Stock buybacks are designed to benefit existing investors in the company when using this system.

What Are the Benefits of Stock Buybacks?

The most common way to increase shareholder value is to pay dividends to stockholders, but stock buybacks come with several additional benefits, including:

Increased Share Prices

Investors will often look at the average return of stocks when placing their bets. Companies with a long record of paying increasing dividends to shareholders will see their stock prices rise over time.

But paying more dividends to stockholders doesn’t always lead to higher share prices. The price of the stock comes down to demand. Stock buybacks increase demand for the stock, which will increase the price per share. The board may also decide to purchase the company’s stock if they feel it is undervalued, making it a good time to buy.

The stock buyback announcement is also a show of confidence to investors. It shows that the owners expect the company’s value to rise in the future. Otherwise, there would be no reason for the company to buy its own stock.

Tax Incentives

Share buybacks are an effective way to increase shareholder value without increasing the individual tax burden. Dividends paid to shareholders are taxed like regular income, with the U.S. federal income tax rate ranging from 0% to 37%. However, rising share values are not subject to federal income taxes. Shareholders only have to pay taxes when they sell the stock, also known as capital gains. Any stockholder who retains their shares will receive a higher share value without having to pay taxes.

Less Commitment

Companies have several options for rewarding shareholders, but stock buybacks offer added flexibility compared to direct dividends payments. Once the company increases the total dividend payment, it will be under pressure to continue making payments going forward. The company will likely face pushback or revolt from shareholders and board members if it decides to lower the dividend payment in the future. Buybacks are one-offs, while dividends are made on a quarterly basis. Repurchasing stock gives the company more control over the stock price. It won’t face pressure or resistance from shareholders when purchasing its own stock and is not required to do so regularly.

Offset Stock Dilution

Once a company buys back its own stock, these shares are either canceled or held in the company’s treasury reserves. In most cases, the company will cancel the shares, which reduces the number of outstanding shares. Canceling shares reduces the number of shares in existence, so the remaining stockholders will receive a larger portion of the dividends. Every shareholder will receive a certain portion of the profits based on the number of shares they own compared to the number of shares outstanding.

Growing companies often use stock options to attract top talent. But the value of these shares will decrease as the company continues to sell shares to raise capital. Buying back shares offsets dilution to increase the value of the original shareholders.

Improved Metrics

Stock buybacks will affect a series of key metrics related to the company’s performance. If the company cancels the shares it buys back, it will increase its earnings per share (EPS) by reducing the number of outstanding shares. Improving the EPS can make it seem like the company is performing well.

It also increases the price-to-share ratio (P/S ratio), which shows investors a company’s relative valuation by comparing its stock price to its EPS.

What Are the Disadvantages of Stock Buybacks?

Stock buybacks are good for shareholders, but they can also have a negative effect on the company’s finances. Any money the company uses to purchase stocks is removed from the balance sheet.

Lack of Development

In some cases, stock buybacks are not seen as a good use of cash. They will increase the value of the company’s stock in the short term, but this may be short-lived if the company fails to innovate or invest in its operations. Most companies need to continually invest in research and development to succeed in the long run.

Using Debt to Buy Back Stocks

Companies also run the risk of running into financial trouble if they use debt to purchase stocks. Low interest rates incentivize companies to take out loans to buy stocks, but the stock price increase tends to be temporary, and the company will still need to repay the debt plus interest.  

High Stock Prices Without Higher Dividends

Companies that repurchase their stocks tend to be rich with excess cash they have saved up after years of strong earnings reports. Cash-rich companies prefer to retain their earnings at the expense of paying dividends. These companies may have a higher stock valuation but may not benefit shareholders as much as companies that pay traditional dividends.

Executive Compensation

Stock buybacks can also be used to conceal compensation to executives. Many corporations pay executives in the form of stock options, which dilutes existing shareholders. Stock buybacks would offset this dilution to increase the value of the executive’s stocks.

The Bottom Line

Stock buybacks are used to increase shareholder value. The move increases demand for the company’s stock, which also raises the market price. Stockholders that retain their shares will see their value increase. They also don’t have to pay taxes until they sell the shares. Companies use stock buybacks to increase the stock price temporarily, but it will be short-lived if they fail to invest in research and development or use too much debt to purchase stocks. Companies need to use their money wisely to succeed in the long term while keeping shareholders happy.