Why Would a Company Buy Back Its Shares?

Dec 11, 2023 By Susan Kelly

Buybacks of stock occur when the firm that first issued the shares goes out and repurchases them. A buyback takes place when the issuing firm re-absorbs that proportion of its own previously dispersed among investors and companies in exchange for the payment of the value determined to the shareholders.

When a firm engages in stock buybacks, also known as share buybacks, it has the option of purchasing the shares on the stock exchange or directly from its shareholders. Buybacks of existing stock have supplanted dividend payments in recent years as the most popular method for companies to repay funds to their shareholders. Due to the high expense required, blue-chip businesses are significantly more likely to choose to execute buybacks than smaller companies, even though the former has the option to do so.

What is Repurchasing of Stock?

A stock buyback occurs when a publicly-traded firm utilizes its cash resources to make market-based purchases of its shares of stock. A firm can do this if it has extra cash on hand that it doesn't need to use for running the business or making other investments.

The most common question to deal with is why do companies buy back shares? During a stock buyback, a company buy back of own shares from the resale market of any shareholders looking to unload their holdings. Shareholders are not required to sell their shares back to the firm, and a stock repurchase does not target any particular set of holders. It is accessible to anybody who owns the company's stock.

How Share Repurchases Influence a Company's Value

Stock repurchasing may have a significant influence on the primary indicators that investors use to determine the value of a public business since they remove cash from a firm's balance sheet and have the ability to lower the number of shares that are outstanding.

It is essential to have a solid understanding that after a business has repurchased its shares, those shares are canceled, resulting in a long-term reduction in the total number of shares in circulation, or maintained by the firm as treasury shares. Because these are not recorded as outstanding shares, this affects a variety of crucial metrics are used to evaluate the fundamentals of a company's finances.

The net profit of a corporation is divided by the total number of shares that are currently in circulation to arrive at critical metrics such as profits per share (EPS). If the number of outstanding shares of a firm is reduced, the company will have higher earnings per share (EPS), creating the impression that the company is doing better financially.

The same holds for the price-to-earnings ratio, often known as the P/E ratio. This metric, which compares a company's stock price to its earnings per share (EPS), provides investors with a better understanding of the relative value of a business.

Methods to Perform Repurchasing of Shares

A company may perform a repurchase in two ways:

  • By tender offer
  • By open market

Tender Offer

The firm's shareholders are sent a tender offer, which demands that they submit, or tender, either a percentage or all of their stock within a certain amount of time. The valuation for the shares will be specified in the offer, along with the number of shares that the corporation is looking to repurchase. Investors interested in taking advantage of the offer are required to provide information on the price and number of shares that they are prepared to sell. After the business has acquired all of the bids, it will figure out the best combination to purchase the stocks at the lowest possible price.

The market often views a repurchase as a favorable indication for a firm. As a result, the share price typically skyrockets in the days and weeks that immediately follow a buyback.

Open Market

A corporation may also choose to purchase its stocks on the marketplace at the current price. On the other hand, it is common practice that the revelation of repurchase will trigger a sharp increase in the cost of the company's shares since the market views this information as a bullish indication.

Why Do Companies Buy Back Their Stock?

There are various advantages of buying back of shares, among which some most common reasons are going to discuss below.

Increased shareholder value

Profitable firms gauge stock success in different ways. However, profits per share are most prevalent. EPS is the most significant factor in stock valuation. It's the company's earnings per share of common stock.

Companies that purchase back shares lower their balance sheet assets and boost their ROA. EPS will improve by reducing outstanding shares and maintaining profitability. Non-selling shareholders have a more considerable percentage of firm shares and a more significant value of shares. Those that sell do so at a cost they're willing to.

Share price increase

Share prices might fall due to weaker-than-expected earnings when the economy falters. When a firm feels its shares are cheap, it will seek a repurchase program.

Companies repurchase shares and resell them once the price reflects the company's worth. After buybacks are announced, share prices will rise when EPS increases. Supply and demand frequently determine this. When shares are in short supply, demand drives up prices.

Tax breaks

Owners can delay investment income if share prices rise by repurchasing business stock instead of boosting dividends. Buybacks are taxed as capital gains, whereas dividends are regular income. Stock held for more than a year have lower capital gains rates.

Spend more money

Buybacks show investors a corporation has extra cash. Investors won't have cash flow issues if a corporation has excess cash. It offers investors that the corporation would instead repay shareholders than reinvest in other assets. This boosts the stock price and gives investors long-term security.

Disadvantages of Share Repurchasing

Investors love buybacks, but they have significant downsides. Many corporations reacquire their stocks artificially to inflate their share prices, suggesting a marketing peak. Buybacks can improve executive pay if earnings can't be boosted. Any share price gain benefits short-term investors over long-term investors when buybacks are disclosed. This sends the market a misleading signal that earnings grow organically, damaging value.

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