Definition of share buyback


What is a share buyback?

Share buyback is a transaction whereby a company buys its own shares on the market. A company may buy back its shares because management considers them undervalued. The company buys shares directly on the market or offers its shareholders the option to offer their shares directly to the company at a fixed price.

Also known as a share buyback, this action reduces the number of shares outstanding, increasing both the demand for shares and the price.

Key takeaways

  • The buyback or repurchase of shares is a decision of a company to buy back its own shares in the market.
  • A company could buy back its shares to increase share value and improve financial statements.
  • Companies tend to buy back shares when they have cash on hand and the stock market is on the rise.
  • There is a risk that the share price will fall after a share buyback.

Understanding Stock Buyback

Because a share buyback reduces the number of shares outstanding, it increases earnings per share (EPS). A higher EPS raises the market value of the remaining shares. After the buyback, the shares are canceled or held as treasury shares, thus they are no longer publicly held and not in circulation.

The share buyback impacts the financial statements of a company in several ways. A share buyback reduces a company’s available cash, which is then reflected on the balance sheet as a reduction for the amount the company spent on the buyback.

At the same time, the share buyback reduces shareholders’ equity by the same amount on the liability side of the balance sheet. Investors interested in how much a company has spent on share buybacks can find the information in its quarterly earnings reports.

Reasons for share buyback

Share buyback reduces the company’s total assets, so its return on assets, return on equity, and other metrics improve compared to no share buyback. Reducing the number of shares means that earnings per share (EPS), income and cash flow grow faster.

If the company pays the same total amount of money to shareholders annually in dividends and the total number of shares decreases, each shareholder receives a higher annual dividend. If the corporation increases its earnings and its total dividend payment, decreasing the total number of shares further increases dividend growth. Shareholders hope that a corporation that pays regular dividends will continue to do so.

Buybacks can raise the price of stocks and make financial statements appear more robust.

In some cases, a buyback can hide a slightly decreasing net income. If the share buyback reduces outstanding shares more than the drop in net income, EPS will increase regardless of the financial status of the company.

Stock buybacks fill the gap between excess capital and dividends so that the business performs more for shareholders without getting hooked on a pattern. For example, suppose the corporation wants to return 75% of its profits to shareholders and keep its dividend payment rate at 50%. The company returns the remaining 25% in the form of a share buyback to supplement the dividend.

Advantages and disadvantages of share buyback

Advantage

A share buyback shows that the corporation believes its shares are undervalued and is an effective method of putting money back into the pockets of shareholders. The share buyback reduces the number of existing shares, making each one worth a greater percentage of the corporation. The EPS of the stock increases while the price-earnings ratio (P / E) decreases or the price of the stock increases. A share buyback shows investors that the company has enough cash set aside for emergencies and a low probability of financial problems.

Disadvantages

One criticism of buybacks is that they are often inopportune. A company will buy back shares when it has a lot of cash or during a period of financial health for the company and the stock market. A company’s stock price is likely to be high at such times, and the price could drop after a buyback. A drop in the stock price may imply that the company is not so healthy after all.

Additionally, a share buyback can give investors the impression that the corporation has no other profitable growth opportunities, which is a problem for growth investors seeking increases in income and earnings. A corporation is not required to buy back shares due to changes in the market or the economy. The share buyback puts a company in a precarious situation if the economy suffers a recession or the company faces financial obligations that it cannot meet.

www.investopedia.com

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Mark Holland

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