Stock Buybacks: What Is It And Why It's Done?

What Do We Mean By Stock Or Share Buybacks?

A stock buyback, also known as a "share repurchase", is a company's buying back its shares from the general public. We already know two most common ways in which company return value to the shareholders, and these are stock appreciation and dividends. The third one is stock buyback. When company buy its own shares, because it can not act as its own shareholder, these shares are owned by the company and the number of shares outstanding is reduced by that amount. As a result, every shareholder of the company now has larger % share in the company, and also has a larger EPS or earnings per share (we'll talk about meaning of that in later posts).

Why Would Company Buyback It's Own Shares?

When company make profit, it has two options: pay that money to its shareholders or reinvest it in the business. Usually, company do both, pay some dividend and keep rest of the profit as a retain earnings. But, there are times when management of a company do not see good opportunity to invest, or their main business is non worth investing in. Example is Berkshire Hathaway company. Their chairman, now investment legend Warren Buffett, used companies profits and cash flow from textile business to acquire shares in other companies, because he realized that textile industry was with low profit margins and that that had strong competition from China.

1st. Reason:

So when there are no other better options to put money to good use, last option is share repurchase or stock buyback. When a company repurchases its own shares, it reduces the number of shares held by the public. The reduction of shares held by the public (also known as a float) means that even if profits are the same, earnings per share will increase. Also, if company's share price is undervalued or depressed, share buybacks will improve return on investments.

2nd. Reason:

Other aspect of stock repurchases is this: if a company's management see that it's stock price is low, or that it is lower than actual book value (more about that in future posts) and currently trading below its intrinsic value, they will consider repurchases.

 3rd. Reason:

Another reason why management prefer share buybacks is that because their compensation is often tied to their ability to meet earnings per share targets. In companies where there are few opportunities for organic growth, share repurchases may represent one of the few ways of improving earnings per share in order to meet targets. It is important to understand that increasing earnings per share does not equate to increase in shareholders value. This investment ratio is influenced by accounting policy choices and fails to take into account the cost of capital and future cash flows, which are the determinants of shareholder value.

4th. Reason:

Share repurchases avoid the accumulation of excessive amounts of cash in the corporation, because companies with strong cash generation will accumulate cash on the balance sheet, which makes the company a more attractive target for takeover, since the cash can be used to pay down the debt incurred to carry out the acquisition (also known as Leveraged buybacks - LBO). Anti-takeover strategies therefore often include maintaining a low cash position and the share repurchases increase stock price which makes a takeover more expensive.

5th. Reason:

Share repurchases also allow companies to covertly distribute their earnings to investors without inflicting them with double taxation.

In latter post I'll cover pros and cons of stock buybacks.