Learn how and why companies do stock buybacks, the different types of buybacks, and whether buybacks are good for investors.
What Is a Buyback?
Individuals and institutions buy shares of stock in a company to see their investment grow through appreciation in the stock price or dividends. Another way for a company to return value to its investors is through stock buybacks. In a stock buyback, a company buys shares of its own stock. Then, it either permanently removes them from circulation or retains them for resale to the market in the future. Decreasing the total shares of stock outstanding increases the ownership stake that each remaining share of stock represents. This increases the value for shareholders.
Alternate name: Share repurchase
How Do Buybacks Work?
Stock buyback plans are often proposed by executives and authorized by a company’s board. But announcing a planned buyback does not always mean it will occur. In some cases, the target share price a company selects may not be met, or a tender offer may not be accepted.
An Example of a Stock Buyback
Let’s say a company has 100,000 shares of stock outstanding at $50 per share for a market capitalization of $5 million. The company has had a few good years in a row, but its stock price remains flat and does not reflect that growth. Executives may feel the stock is undervalued. They decide to initiate a stock buyback. The executives use $1 million of cash from net profits to purchase 20,000 shares at the same $50 per share price. This purchase decreases the total outstanding shares to 80,000. Each share no longer represents the 0.001% ownership it did when there were 100,000 available shares. Instead, it represents 0.00125%, a 20% increase in value per share.
Types of Buybacks
There are two types of buybacks: open market and tender offer.
Open Market
Companies may repurchase shares on the open market at prescheduled times or when management feels it is the best use of capital.
Tender Offer
In a tender offer, the company offers to buy back its shares. This offer is often at a higher price than what the shares cost on the open market. All tender offers are subject to regulation by the Securities and Exchange Commission (SEC). A tender offer may also come from a third party looking to gain a controlling share of the company. In this case, the transaction is a third-party tender offer and not a buyback.
Alternatives to Buybacks
Stock buybacks are one way a company can use capital to increase shareholder value. Other options include:
Returning cash on hand to investors in the form of dividends Reinvesting capital in research and development Using capital to acquire securities or other companies
Alternatives are an important part of understanding buybacks; buyback programs have come under scrutiny in the past few years.
Buyback Criticism and Drawbacks
Companies are often criticized for share repurchases. Some have argued that firms repurchase shares to meet short-term goals at the expense of long-term ones. Another drawback is that companies open up vulnerabilities when they go into debt to purchase stock. The move may be costly if a company repurchases shares at a price that proves to be overvalued. There is also some concern that decisions to repurchase shares are often made to enrich corporate executives. At the same time, it may slow stock growth rates and create long-term declines in earnings for workers. Shareholders could take issue with buybacks, too. They may prefer dividends over buybacks. That way, they can control how their returns are reinvested. They can purchase their own additional shares through a dividend reinvestment plan (DRIP). Or, they can put the cash to work in some other fashion.
Buybacks vs. Dividends
A dividend payment represents cash in hand for an investor or more shares of a stock for those who reinvest dividends. A share buyback provides no immediate return to an investor. But it could prove to increase the company’s value while deferring tax consequences. “We actually think that dividends vs. share buybacks is something of a false dichotomy,” Morningstar strategist Dan Lefkovitz said in a company video about buybacks. “The fact is that many companies these days do both. Share buybacks have become a lot more prominent and have, in fact, eclipsed dividends as a means of returning cash to shareholders.
What a Buyback Means for Individual Investors
Whether a share buyback is good or bad for individual investors is not a simple question. Many variables factor into the answer: the share price at the time of purchase, whether better investment options exist, and whether an investor prefers dividends.
