What Is a Buyback?

A buyback, also known as a share repurchase, is when a company buys its own outstanding shares to reduce the number of shares available on the open market. Companies buy back shares for a number of reasons, such as to increase the value of remaining shares available by reducing the supply or to prevent other shareholders from taking a controlling stake.

Understanding Buy backs

A buyback allows companies to invest in themselves. Reducing the number of shares outstanding on the market increases the proportion of shares owned by investors. A company may feel its shares are undervalued and do a buyback to provide investors with a return. And because the company is bullish on its current operations, a buyback also boosts the proportion of earnings that a share is allocated. This will raise the stock price if the same price-to-earnings (P/E) ratio is maintained.

The share repurchase reduces the number of existing shares, making each worth a greater percentage of the corporation. The stock’s EPS thus increases while the price-to-earnings ratio (P/E) decreases or the stock price increases. A share repurchase demonstrates to investors that the business has sufficient cash set aside for emergencies and a low probability of economic troubles.

Another reason for a buyback is for compensation purposes. Companies often award their employees and management with stock rewards and stock options. To make due on rewards and options, companies buy back shares and issue them to employees and management. This helps avoid the dilution of existing shareholders.

Because share buybacks are carried out using a firm's retained earnings, the net economic effect to investors would be the same as if those retained earnings were paid out as shareholder dividends.

How Companies Perform a Buyback

Buybacks are carried out in two ways:

• Shareholders might be presented with a tender offer, where they have the option to submit, or tender, all or a portion of their shares within a given time frame at a premium to the current market price. This premium compensates investors for tendering their shares rather than holding onto them.
• Companies buy back shares on the open market over an extended period of time and may even have an outlined share repurchase program that purchases shares at certain times or at regular intervals.

A company can fund its buyback by taking on debt, with cash on hand or with its cash flow from operations.

An expanded share buyback is an increase in a company’s existing share repurchase plan. An expanded share buyback accelerates a company’s share repurchase plan and leads to a faster contraction of its share float. The market impact of an expanded share buyback depends on its magnitude. A large, expanded buyback is likely to cause the share price to rise.

The buyback ratio considers the buyback dollars spent over the past year, divided by its market capitalization at the beginning of the buyback period. The buyback ratio enables a comparison of the potential impact of repurchases across different companies. It is also a good indicator of a company’s ability to return value to its shareholders since companies that engage in regular buybacks have historically outperformed the broad market.

Important Points

• A buyback is when a corporation purchases its own shares in the stock market.
• A repurchase reduces the number of shares outstanding, thereby inflating (positive) earnings per share and, often, the value of the stock.
• A share repurchase can demonstrate to investors that the business has sufficient cash set aside for emergencies and a low probability of economic troubles.

Criticisms of Share Buybacks

• A share buyback can give investors the impression that the corporation does not have other profitable opportunities for growth, which is an issue for growth investors looking for revenue and profit increases. A corporation is not obligated to repurchase shares due to changes in the marketplace or economy.
• Repurchasing shares puts a business in a precarious situation if the economy takes a downturn or the corporation faces financial issues it cannot cover. Others allege that sometimes buybacks are used to inflate share price artificially in the market, which can also lead to higher executive bonuses. (For related reading, see "4 Reasons Investors Like Buybacks")