How Share Buybacks Influence Stock Prices
Share buybacks are one of the most common capital allocation strategies that public companies use. Rather than paying out the excess cash in the company as dividends, the firm purchases its own outstanding shares from the stock market. This share buyback influences several factors regarding the company’s stock.
As investors, it is essential to understand how share buybacks work as they impact both the short and the long term returns for shareholders. Companies may buy back their shares to signal to the public and the markets the confidence that the management team has in the company’s operations and future returns.
What Is a Share Buyback?
A share buyback, or stock repurchase, occurs when a company purchases some of its outstanding shares from investors.
The company can use these repurchased shares for several purposes:
Retire the shares
Hold them as treasury shares
Issue them to employees for stock plans
Use them for future company transactions
By reducing the number of shares outstanding, the percentage of ownership that shareholders hold will decrease for each share they own, and a company’s financial metrics will improve.
Why Companies Repurchase Shares?
Companies authorize share buybacks for several reasons.
The most common reasons for share buybacks are to:
Return capital to shareholders
Increase earnings per share
Improve financial ratios
Offset employee stock compensation
Indicate confidence in the company
Use excess company cash effectively
Company management decides on share buybacks as one of the possible options for allocating excess company capital to other areas.
Impact on Earnings Per Share
The share buyback will impact the company’s earnings per share (EPS).
Since the company will have fewer shares outstanding, the company’s earnings will have fewer shares to distribute the earnings to.
For example, if a company makes $100,000 in a year and has 100,000 outstanding shares, its earnings per share will be $1. If the company purchases back 10,000 shares that are outstanding, its earnings per share will increase to $1.10 because it will have distributed its $100,000 earnings to only 90,000 shares.
The improved ratio for a company after a share buyback will attract the attention of investors as it indicates that the company is operating more efficiently.
Buybacks and Stock Valuations
A company’s share buyback can impact its stock valuation for several reasons.
As shares are bought back by a company, its stock valuation will increase because the company will have fewer shares outstanding. Additionally, investors will perceive a company’s share buyback as a sign of its management’s confidence in the company, which can impact the company’s valuation.
However, a share buyback will not impact a company’s stock valuation unless the company follows the proper procedure when repurchasing its shares. If a company overpays for its shares and uses the company’s profits to purchase its shares back, its stock valuation in the future will suffer.
Buybacks vs. Dividends
Both share buybacks and dividend payments allow a company to return capital to its shareholders.
However, the two strategies achieve different objectives for the company.
Share Buybacks
Companies undertake share buybacks to:
Reduce the number of shares that are outstanding
Increase the percentage of ownership that shareholders have in the company
Provide the company with more flexibility in how it spends its funds
Increase its earnings per share
Dividends
A company pays dividends to shareholders to:
Provide regular income to shareholders
Attract investors who require a regular income from their investments
Demonstrate the financial stability of the company
Provide shareholders with returns from their company investments
Many companies that have finished developing their operations and are now in the maintenance and profit growth phase use both share buybacks and dividends to manage their excess capital.
Evaluating Buyback Quality
Not all share buybacks will benefit the shareholders.
Investors should evaluate how much a company values its shares and whether it has the available cash flow and debt capacity to undertake a buyback program. Additionally, investors should determine the company’s future investment opportunities and the current state of its balance sheet and its long-term growth strategy.
A company’s best outcome from a share buyback program will occur when the company repurchases some of its undervalued shares using its available excess cash. In contrast, if the company must borrow heavily to undertake a share buyback, it will expose the company and its shareholders to financial risk.
Market Conditions Influence Buyback Activity
A company’s share buyback activity can change throughout the economic cycle.
For example, a company will undertake more share buybacks when it has more available cash, higher profits, and more attractive share valuations. During economic downturns or periods of declining company profits, a company may reduce or eliminate its share buyback program.
By monitoring the share buyback activity of a company, investors can gain valuable insight into the management’s perspective and intentions for its company.
Risks Investors Should Understand
Investors should be aware of the risks of a company undertaking a share buyback program.
The risks of a share buyback program include the company overpaying for its shares, increasing its corporate debt, reducing its investments in the company’s future growth, and forcing the company to focus on short-term growth rather than long-term sustainability of its business.
Therefore, investors must recognize that a company’s share buyback does not mean the company is undertaking a positive action with the shareholders’ money.
A company’s financial position is the most essential consideration for investors.
How Institutional Investors View Share Buybacks?
Institutional investors carefully analyze a company’s share buyback program.
They look at a company’s free cash flow, return on invested capital, capital allocation strategy, potential for long-term earnings growth, balance sheet, and executive incentives.
The best time for a company to undertake a share buyback is when the company is operating well and earning high returns as opposed to when it is experiencing a slowdown in its growth and profits.
Key Takeaways
A company undertakes a share buyback to reduce the number of shares that are outstanding.
By reducing the number of shares that are outstanding, the company can improve its earnings per share without making any profits.
Share buybacks are one of the methods a company can use to return capital to its shareholders.
Investors can use the company’s financial position and share buyback program to evaluate the potential value of the company’s shares for the long term.
If a company repurchases its undervalued shares with excess cash, it can create value for the company’s shareholders over the long term.
A company’s best performance with a share buyback happens when the company is already experiencing strong business and financial performance relative to its industry.
Conclusion
Share buybacks influence so many aspects of a company’s stocks, from the mathematical metrics that investors use to evaluate the company’s potential to the sentiment that investors feel when they decide to invest in that company’s stock. While share buybacks can create value for a company and its shareholders, they should never be evaluated in isolation from the other aspects of a company’s financial position. By understanding why a company undertakes a share buyback, investors can make better decisions about where to allocate their money for maximum benefit within today’s equity markets.