Why Do Companies Buy Back Shares?
EA
Summary:
When public companies want to share business profits with their shareholders, they can buy back their own shares as a form of compensation to participating investors. Share buybacks come with tax advantages and balance sheet advantages for shareholders and companies. As an investor, you should care about stock buybacks.
In terms of total dollar value provided to stock investors, buybacks surpassed dividends long ago, in 1997 to be exact. Profit-sharing with current investors can attract new investors and boost a company’s value. A stock buyback decreases the number of slices of the earnings pie, leaving bigger slices for current investors. If you own a company’s stocks, you own a piece of that company’s pie, and you may face a buyback at some point. Keep reading to learn about what stock buybacks are and how they could affect you.
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How companies spend profits
When a company makes a profit, it must decide how to best allocate that cash. It’s up to business executives and shareholders to strategize and vote on how the company’s money is to be spent. Here are a few of the most common company cash outflows:
How to spend company profits
Congratulations, Board of Directors, you’ve beat your earnings forecasts and analysts’ estimates. Now what? You have several options.
- Investing back into operations: Growth is the goal for almost any business. To continue growing, a business must invest back into itself. This can mean investing in a wide variety of operations. Internal investments may include upgrading equipment, hiring new employees, or investing in marketing.
- Paying off debts: Businesses can take on debt in the form of loans or credit card debt, just like individuals. It is wise for a company to strategically manage its debt and use profits to pay them down incrementally.
- Paying dividends to investors: Some public companies use their cash to pay out dividends to investors. Dividend payments are fractions of a company’s profits that it shares with investors based on the number of shares they own.
- Acquiring another company: Larger corporations often buy other companies to scale, diversify, dominate, or optimize. Acquiring another company is a big decision no matter the size of the company.
- Stock buybacks: A company may also use excess cash to — you guessed it — buy back its own shares of stock. Based on the needs of a business, management can decide to buy back company stock. You’ll learn all about this strategy in the rest of this article.
What is a stock buyback?
Individual stocks are essentially small portions of ownership in a company. The value of this ownership fluctuates depending on the market and the operations of the company. There are many nuances when it comes to stock values and investing, but understanding the basics of stocks will help you comprehend stock buybacks.
A stock buyback is also known as a share repurchase, share buyback, share repurchase program, or stock buyback program. Stock buybacks occur when a company buys outstanding shares of its own stock in the open market. Outstanding shares refer to stock currently owned by all of a company’s shareholders.
There are several reasons and methods for a company to buy back shares. Typically, companies buy back their own shares to create value for their current investors. When there are fewer shares of a company available, the value of each share remaining goes up.
How do stock buybacks work?
If company executives decide that they want to use excess cash to buy back shares, they will need to issue a “repurchase authorization,” which describes the details of the repurchase for shareholders’ reference.
Repurchase authorizations tell you:
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In 2021, the United States Securities and Exchange Commission (SEC) proposed updated requirements for companies to disclose more detail in repurchase authorizations. Stock buybacks had increased dramatically over the preceding decade. In fact, stock buyback volume reached $700 million in 2020. For this reason, the SEC began advocating more transparency for investors.
After authorization, a company may or may not repurchase shares. A company buys a number of outstanding shares from the open market, just like a regular investor. It cannot force stockholders to sell shares. Selling may be in the best interest of investors. It is up to individual investors to assess the repurchase authorization and determine how selling their shares back to the company — or not — benefits them.
Know your interested parties — For a comprehensive understanding of contemporary businesses, you’ll want to learn about more than just shareholders. Make sure you also understand the difference between shareholders and stakeholders.
Pros and cons of stock buybacks
As with any business decision, a company’s management team must weigh the costs and benefits of a stock buyback. It’s fair to wonder: why would a company want to initiate a stock buyback in the first place? While a stock buyback has several potential advantages, a company has to consider some potential disadvantages also. Let’s imagine you’re on the management team and must consider some of the most important advantages and disadvantages of stock buybacks.
What does a stock buyback mean for me?
A stock buyback can be good or bad news. It depends on the nature of the buyback and the state of the company.
A company cannot force you to sell your stocks, but it may be in your best interest to do so. It could also be a good time to hold stocks and watch their value increase.
If you own shares in a company that is doing well and has cash outflows, this could be good news for you. If a company repurchases shares while other parts of the business are failing, it may be forfeiting future growth, which will cost you in the future. This is bad news, and you may want to sell.
Pro tip: distinguishing good buybacks from bad
If you are wondering whether a buyback is a good thing or not, research the company, its executives, and its repurchase authorization. Look at the company’s short interest to understand more about its performance. Then ask some key questions.
Good or bad buyback: how to decide
Ask these four questions:
- What is the reason for the repurchase?
- Is the buyback concealing shares issued to management?
- Are the shares being repurchased at good stock prices?
- Does management have a strong track record of delivering returns?
Why do companies buy back their own stock?
Companies buy back their own stock for several reasons. They may want to generate tax-advantaged returns for investors. They may also buy back their own stocks to artificially inflate their valuation or conceal internal share distribution.
Is it good when companies buy back their shares?
Whether stock buybacks are good depends on the financial metrics of a company, the company’s shares, and the reason for repurchasing shares.
What are the disadvantages of buyback of shares?
Disadvantages of buying back shares include taking on debt, foregoing future gains, and diluting shareholder value.
Your investor learning doesn’t have to stop at buybacks. There’s plenty more to discover with SuperMoney. Here’s a recommendation: learn about par value next.
Key takeaways
- A stock buyback occurs when a company decides to repurchase shares outstanding. There are several reasons a company might choose to do this, but the most common is to compensate investors and increase the value and earnings per share for shareholders.
- Companies must issue a repurchase authorization before initiating a share repurchase program. In 2021, the SEC began advocating increased transparency requirements for the benefit of investors.
- Stock buybacks can be great for both companies and their investors as long as the companies have enough cash, are transparent with investors, and spend the cash wisely. It is risky for companies to take on debt for stock buybacks.
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