Why Do Companies Buy Back Shares?
How Do Share Buybacks Work?
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Publicly traded companies set aside their own funds to purchase the stock from private stockholders on the open market. This may seem counterintuitive, considering companies sell shares to raise capital. But creating new shares in the company dilutes the value of each share. During a stock buyback, the company will purchase a certain amount of its stock on the open market and then delete the shares. The company’s market capitalization stays the same, minus the money it spent to purchase the shares. The value of each share — a key metric for shareholders and investors — increases as a result.
A company with 100,000 shares plus a fund manager technically has 100,001 shares. If the company pays a total of $1 million in dividends every quarter, the money will need to be distributed among all 100,001 shareholders. In this case, each person would only receive $9.99 per quarter ($1 million / 100,001 = $9.99).
A share buyback increases the value of all remaining shares because each person receives a greater share of the profits. If the company buys back 50,000 shares, the number of shares outstanding drops to 50,000. The $1 million dividend payment is then $50,000 instead of $100,000. After the stock buyback, each stockholder would receive $19.99 per quarter ($1 million / 50,001 = $19.99).
- Increase Shareholder Value
The main reason companies buy back shares is to increase shareholder value. Companies can increase shareholder value in several ways, mainly by paying dividends to shareholders, but paying dividends costs equity. The company can use this money to purchase its own stock on the open market to increase the value of each share. This returns value to the shareholders because they will receive a greater share of the dividends, and the price of the stock will likely increase.
- Offset Dilution
Companies will often sell shares to raise capital while growing their operations. But the company’s stock will eventually run out of room to grow. Creating new shares dilutes the value of the remaining shares, and the company runs the risk of spreading its profits too thin if it creates too many shares. The company can offset dilution by purchasing its own stock and deleting the shares from existence.
- Consolidate Ownership
Share buybacks also decrease the number of stockholders, which helps the company consolidate ownership. Every share represents a stake in the underlying company. It gives the person a say on important issues and influence within the company. The company may decide to scale back the number of shareholders to limit outside influence.
- Stabilize Stock Prices
A company may also buy back stock if the price is dropping quickly. If the company’s stock price is dropping, the company can try to temporarily increase the price or stop it from falling any further by purchasing its own stock. This creates demand for the stock, which increases the price per share. The boost will be temporary unless the company can turn its fortunes around.
- Increased Flexibility
Publicly traded companies face pressure to continue making quarterly payments once they start paying dividends to shareholders. But the company needs to balance its obligations to shareholders with the financial needs of the company. Should the economy dip into a recession, the company may need to scale back the size of the dividend payment, which would lead to a sell-off in the market. Instead of reducing dividends, the company can reduce the number of shares it buys back, which would minimize panic among investors.
- The Stock Is Undervalued
If the company’s executives believe it is undervalued and poised for growth in the future, they will buy the shares on the open market at the reduced price and then reissue them once the market has improved. The company will profit from the price increase without having to issue any new shares.
- Improve Financial Ratios
Finally, buying back shares improves several key financial ratios for the company, including its earnings per share (EPS) and the price-to-earnings ratio (P/E ratio). The EPS divides the company’s total earnings by the number of shares outstanding. Reducing the number of shares increases the EPS because the earnings are divided by fewer shares. The P/E ratio measures the price of the stock compared to the average earnings per share. The price of the stock will likely increase during a stock buyback while the EPS increases.
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Is It Good for a Company to Buy Back Shares?
Share buybacks tend to benefit companies and the larger economy, but the effect isn’t distributed evenly. These moves tend to benefit the company’s finances and the financial market by boosting stock prices. Still, some companies may not have enough money left over to expand their operations and create jobs.
However, the move can damage the company’s credit rating if it needs to borrow money or take out a loan to buy the shares. The company will still have to pay back the loan, even though the interest is tax deductible, and the stock buyback doesn’t guarantee an increase in equity. Stock buybacks can drain a company’s finances, which limits its potential for growth. It may also have to reduce dividends or sell off assets during a recession if it doesn’t have enough cash in reserves.
Stock buybacks are becoming increasingly common in today’s economy as a way of increasing shareholder value. They tend to be more popular during times of recession because it gives companies more flexibility in terms of how they reward shareholders. The move can also be used to temporarily boost stock prices by creating demand for the company’s stock. It is often seen as an alternative to paying dividends to shareholders. Both increase shareholder value, but stock buybacks have additional benefits that may shape the company’s reputation among investors.