Buyback

What Is a Buyback?

A buyback, also known as a share repurchase, is when a company buys its own outstanding shares to reduce the number of shares available on the open market.

Companies buy back shares for a number of reasons, such as to increase the value of remaining shares available by reducing the supply or to prevent other shareholders from taking a controlling stake.

Understanding Buybacks

A buyback allows companies to invest in themselves. Reducing the number of shares outstanding on the market increases the proportion of shares owned by investors. A company may feel its shares are undervalued and do a buyback to provide investors with a return. And because the company is bullish on its current operations, a buyback also boosts the proportion of earnings that a share is allocated. This will raise the stock price if the same price-to-earnings (P/E) ratio is maintained.

The share repurchase reduces the number of existing shares, making each worth a greater percentage of the corporation. The stock’s earnings per share (EPS) thus increases while the price-to-earnings ratio (P/E) decreases or the stock price increases. A share repurchase demonstrates to investors that the business has sufficient cash set aside for emergencies and a low probability of economic troubles.

Another reason for a buyback is for compensation purposes. Companies often award their employees and management with stock rewards and stock options. To offer rewards and options, companies buy back shares and issue them to employees and management. This helps avoid the dilution of existing shareholders.

Because share buybacks are carried out using a firm's retained earnings, the net economic effect to investors would be the same as if those retained earnings were paid out as shareholder dividends (tax considerations aside).

How Buybacks Work

Buybacks are carried out in two ways:

1. Shareholders might be presented with a tender offer, where they have the option to submit, or tender, all or a portion of their shares within a given time frame at a premium to the current market price. This premium compensates investors for tendering their shares rather than holding onto them.
2. Companies buy back shares on the open market over an extended period of time and may even have an outlined share repurchase program that purchases shares at certain times or at regular intervals.

A company can fund its buyback by taking on debt, with cash on hand, or with its cash flow from operations.

The buyback ratio considers the buyback dollars spent over the past year, divided by its market capitalization at the beginning of the buyback period. The buyback ratio enables a comparison of the potential impact of repurchases across different companies. It is also a good indicator of a company’s ability to return value to its shareholders since companies that engage in regular buybacks have historically outperformed the broad market.

Example of a Buyback 

A company's stock price has underperformed its competitor's stock even though it has had a solid year financially. To reward investors and provide a return to them, the company announces a share buyback program to repurchase 10% of its outstanding shares at the current market price.

The company had $1 million in earnings and 1 million outstanding shares before the buyback, equating to earnings per share (EPS) of $1. Trading at a $20 per share stock price, its P/E ratio is 20. With all else being equal, 100,000 shares would be repurchased and the new EPS would be $1.11, or $1 million in earnings spread out over 900,000 shares. To keep the same P/E ratio of 20, shares would need to trade up 11% to $22.22. 

Criticism of Buybacks

A share buyback can give investors the impression that the corporation does not have other profitable opportunities for growth, which is an issue for growth investors looking for revenue and profit increases. A corporation is not obligated to repurchase shares due to changes in the marketplace or economy.

Repurchasing shares puts a business in a precarious situation if the economy takes a downturn or the corporation faces financial issues it cannot cover. Others allege that sometimes buybacks are used to inflate share price artificially in the market, which can also lead to higher executive bonuses.

$1 Trillion

Buybacks in 2018 among all U.S. companies surpassed this amount for the first time in history. Apple, Inc. alone authorized $100 billion in buybacks during 2018.

Why Would Companies Do Buybacks?

A buyback allows companies to invest in themselves. If a company feels that its shares are undervalued then it may do a buyback to provide investors with a return. The share repurchase reduces the number of existing shares, making each worth a greater percentage of the corporation. Another reason for a buyback is for compensation purposes. Companies often award their employees and management with stock rewards and stock options and a buyback helps avoid the dilution of existing shareholders. Finally, a buyback can be a way to prevent other shareholders from taking a controlling stake.

How Is a Buyback Done?

A company can make a tender offer, at a premium over the current market price, to shareholders where they have the option to submit all or a portion of their shares within a given time frame. Alternatively, a company may have an outlined share repurchase program that purchases shares on the open market at certain times or at regular intervals over an extended period of time. A company can fund its buyback by taking on debt, with cash on hand, or with the cash flow from operations. 

What Are Criticisms of Buybacks?

A share buyback can give investors the impression that the corporation does not have other profitable opportunities for growth, which is an issue for growth investors looking for revenue and profit increases. Buybacks can put a business in a precarious situation if the economy takes a downturn or the corporation faces financial issues it cannot cover. Another criticism of a buyback is that it can be used to inflate share price artificially in the market, which can also lead to higher executive bonuses.