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Develop and improve products. List of Partners vendors. There are several ways in which a company can return wealth to its shareholders. Although stock price appreciation and dividends are the two most common ways, there are other ways for companies to share their wealth with investors. In this article, we will look at one of those overlooked methods: share buybacks or repurchases. We'll go through the mechanics of a share buyback and what it means for investors.
A stock buyback, also known as a share repurchase, occurs when a company buys back its shares from the marketplace with its accumulated cash. A stock buyback is a way for a company to re-invest in itself. The repurchased shares are absorbed by the company, and the number of outstanding shares on the market is reduced. Because there are fewer shares on the market, the relative ownership stake of each investor increases. There are two ways that companies conduct a buyback: a tender offer or through the open market.
The company shareholders receive a tender offer that requests them to submit, or tender, a portion or all of their shares within a certain time frame. The offer will state the number of shares the company wants to repurchase and a price range for the shares. Once the company has received all of the offers, it will find the right mix to buy the shares at the lowest cost. The market typically perceives a buyback as a positive indicator for a company, and the share price often shoots up following a buyback.
A company can also buy its shares on the open market at the market price. It is often the case, however, that the announcement of a buyback causes the share price to shoot up because the market perceives it as a positive signal. Why do companies buy back shares?
A firm's management is likely to say that a buyback is the best use of capital at that particular time. After all, the goal of a firm's management is to maximize return for shareholders, and a buyback typically increases shareholder value. The prototypical line in a buyback press release is "we don't see any better investment than in ourselves.
There are other sound motives that drive companies to repurchase shares. For example, management may feel the market has discounted its share price too steeply. Thus, when a company spends millions of dollars buying up its own shares, it can be a sign that management believes that the market has gone too far in discounting the shares—a positive sign.
Another reason a company might pursue a buyback is solely to improve its financial ratios—the metrics used by investors to analyze a company's value. This motivation is questionable. If reducing the number of shares is a strategy to make the financial ratios look better and not to create more value for shareholders, there could be a problem with management.
However, if a company's motive for initiating a buyback is sound, better financial ratios as a result could simply be a byproduct of a good corporate decision. Treasury shares are counted as issued shares, but not as outstanding shares.
Reducing the number of shares outstanding affects calculations such as earnings per share, which in turn affects a widely used valuation metric, the price-to-earnings ratio. If total earnings stay constant, but the number of shares outstanding falls after a buyback, the company's earnings per share will rise.
Taking that one step further, if the company's stock price stays constant but earnings per share rise, its price-to-earnings ratio will fall. Buybacks also reduce the amount of cash on a company's balance sheet. That in turn increases return on assets , because the company's assets cash have been reduced. Return on equity will also rise, because there's less outstanding equity. While a company's share repurchases are generally intended to be bullish for its stock price, there are sometimes reasons for concern.
Critics often contend, with some justification, that companies tend to repurchase shares after a period of success, when they have plenty of cash. This means that the company is repurchasing its stock at a high valuation. A company in that situation could end up buying its shares at a cyclical price peak , getting fewer shares for its money -- and leaving it with less cash in reserve when its business slows.
Investors should also proceed carefully if the buyback appears motivated by management's desire to improve its valuation metrics or put another way, to manipulate them.
A company that uses buybacks to create the appearance of quick growth in earnings per share, for instance, may not be a company worth owning.
As with many things in investing, the answer isn't clear-cut. If the company genuinely has cash to spare, and its shares are arguably undervalued, then a buyback can be a good way to generate benefits for shareholders. But if its shares are expensive, it's worth asking why the company isn't choosing to pay a special dividend to its shareholders instead -- or hanging on to the cash for a rainy day.
Discounted offers are only available to new members. Stock Advisor will renew at the then current list price. Investing Best Accounts. In fact, by reducing the supply of company stock available in the market, buybacks tend to push share prices up, which leaves the remaining shareholders with stock that's more valuable than before.
A stock buyback is solely a balance sheet transaction, meaning that it doesn't affect the company's revenue or profits. When a company buys back stock, it first reduces its cash account on the asset side of the balance sheet by the amount of the buyback. The balance sheet is back in balance. Cam Merritt is a writer and editor specializing in business, personal finance and home design.
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