What is a share buyback? Definition & Effects

Share buybacks are generally viewed as a positive signal by the market.

What is a share buyback?

When a publicly traded company buys back outstanding shares of its own stock on the open market (or directly from existing shareholders), it’s called a stock buyback. When a share buyback takes place, two things happen immediately: the number of shares outstanding decreasesand the proportion of the company each share represents increased.

In other words, after a buyout, existing shareholders (assuming they haven’t sold their own shares back to the company) suddenly have an increased stake in the company, both in terms of percentage ownership and the weight of their vote. rights. A stock buyback is often described as a business “investing in itself”.

Why do companies buy back shares?

Typically, companies buy back shares when they have “extra” cash that is not already earmarked for other investments or operations. This is generally done for two reasons: to increase the value of the shares for investors and to reduce the dilution of the shares.

To increase the stock price

Since price is a product of supply and demand, reducing the supply of stocks in the market should increase demand, which should, in turn, increase the price of the stock, providing thereby providing additional value to existing shareholders.

Since buybacks are notorious for driving up stock prices, the mere announcement of an upcoming buyout often drives stock prices higher as investors scramble to buy ahead of the buyback.

To fight against stock dilution

When a company’s employees exercise their stock options, more shares enter the market, causing each existing share to represent a smaller stake in the company. This effect is known as stock dilution. Buybacks combat stock dilution by removing shares from the market, causing each remaining share to represent a larger stake in the company.

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What are the effects of a share buyback?

Share buybacks have a multitude of effects in several areas. They affect stocks, shareholders, financial ratios and the company itself.

On the stock price

As mentioned above, stock buybacks should, in theory, drive up stock prices for several reasons. First, if the demand for stocks remains the same, but fewer stocks are available, the stocks should trade at higher prices due to their relative scarcity.

Second, since buyouts require valuable cash, companies typically perform them when they are not in desperate need of funds to pay off debt or fund major operations. For this reason, a buyback can be seen as a sign of financial health and stability, which can make a stock more attractive to investors, driving up its price even further.

On financial ratios

  • Return on assets (ROA): Share buybacks require cash, which is a plus. Since redemptions reduce cash, assets (the denominator in the calculation of ROA) are reduced, resulting in a higher return on assets, which is generally viewed as a positive by the market.
  • Return on Equity (ROE): Because buybacks reduce the number of shares outstanding, a company’s equity (AKA book value, the denominator in ROE calculations) decreases, resulting in a higher return on equity, usually considered positive by the market.
  • Earnings per share (EPS): Reducing the number of shares outstanding also increases earnings per share because the same earnings are distributed among fewer shares. The higher a company’s earnings, the more attractive its shares.
  • Price/earnings ratio (P/E): Since buyouts increase EPS (the denominator in calculating P/E), they decrease a company’s price/earnings ratio. The lower a company’s P/E ratio relative to its competitors, the more attractive it is generally to value investors.

About the shareholders

Since buybacks reduce the number of shares a company has outstanding, each remaining share represents a larger stake (and more voting power) in the company. This is a plus for shareholders because the longer they own a business, the more they will see if the value of the business increases. In addition, each share will have a greater impact in terms of the voting rights of its holders when it comes to decisions that could affect the future success of a company.

In addition, since buybacks generally drive up the price of shares, existing shareholders should benefit from these buybacks in the form of capital gains.

About the company

When a company makes a buyout, it spends cash that could have been used for many other purposes, including paying down debt, hiring, research and development, or acquiring new factories, properties or equipment. In other words, its assets decrease.

However, buyouts can also stoke publicity, instill public confidence in a company, and drive up its stock value, which can help it secure additional financing and new investors.

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