When someone buys stock in a company, they ultimately want to see a return on that investment. They can see that return buy buying low and selling high, of course. But they can get a return in other ways, too. The company may offer dividends, stock price appreciation, or share buyback.
This article will focus on buybacks and how they increase shareholder wealth and help companies improve their balance sheets.
What’s a stock buyback?
When a company performs a stock buyback, it buys back its shares from the market. It’s a way for the company to invest in itself or use available cash to purchase its own shares.
The company can either re-absorb the shares or re-issue them at a later date. To buy back the shares, the issuing company pays shareholders the market value per share directly on the open market or through a tender offer.
Reducing the number of available shares makes the remaining shares more valuable. For example, if a company issued 100,000 shares of common stock at $30 per share, it has a market capitalization of $3,000,000.
It has large cash reserves on hand and management decides the best way to use the cash is to do a stock buyback. The company uses $600,000 to buy back 20,000 shares of its own stock. This reduces the available common shares to 80,000 and increases the price per share to $37.50 instead of $30, which makes investors happy.
With recent tax incentives, companies have increasingly used share buybacks as a way to return cash to shareholders. Any publicly traded company—from small cap to blue chip—can use this strategy to keep investors happy.
Why would a company buy back stock?
There are several reasons that a company may decide to buy back its stock.
A stock buyback allows a company to invest in itself and consolidate ownership. It’s also a way to return wealth to investors without increasing dividends. This can be important if the stock price is devalued, or a recession looms on the horizon.
Buying back shares of its own stock can be the best use of capital at a particular time. For example, if a company’s price per share is particularly low, a buyback will boost the price by reducing available shares.
The company may believe the share price is discounted unfairly because of low earnings or a poor economic climate. It uses the buyback to signal that it believes the market is undervaluing the shares and give a positive sign to investors.
Performing a stock buyback can also improve financial ratios such as return on assets (ROA), return on equity (ROE), and the earnings per share (EPS). This is especially true if the company has large cash-on-hand reserves and used them to purchase shares of its own stock.
The higher EPS lowers the company’s price-per-earnings ratio (P/E), which can signal the shares are a better value for investors. The new P/E ratio shows investors the company is now a better value per dollar of earnings even if there is no actual change in earnings.
How does a buyback work?
A buyback typically happens in one of two ways:
1. Open Market Just like any other investor, the company can go on the open market and purchase shares of its own common stock. Rule 10b-18 adopted by the Securities and Exchange Commission (SEC) gives companies “safe harbor” to perform stock buybacks. It allows a company to purchase its own stock as long as it’s not more than 25 percent of average daily volume.
2. Tender Offer Companies can also invite shareholders to “tender” or sell their shares to them. They can make an offer to investors to buy a portion or all of their shares in a certain time frame. Tender offers are almost always higher than the current value of the stock.
Investors who receive the offer will be notified of how many shares the company wants to purchase, at what price range and by what deadline. If you miss the deadline, you won’t be able to sell your stock back to the company and will retain ownership.
Since investors tend to perceive a stock buyback offer from a company in a positive way, it can cause share prices to go up.
Do buybacks affect me?
In short, yes. It’s important to understand how stock buybacks work since they can affect the price of shares you own for a particular company. They can also have a positive overall effect on the economy, which, in turn, can increase consumer confidence.
Investors looking to make quick money in the short term often buy shares of stock leading to a scheduled buyback. This can boost the company’s P/E ratio and inflate the stock’s valuation.
Keep in mind that how a company chooses to return wealth to investors can have an effect on your taxes. If a company decides to increase the dividend payout for its stock, you will pay ordinary income tax on the benefits.
However, the income from selling stock shares has a different tax rate. Traditionally, the capital gains tax rate has been lower than ordinary income tax, providing an advantage for buybacks over dividends.
Since tax rates tend to change frequently, this equation is not always the same. Investors need to look at the cost/benefit ratio of dividends over buybacks and evaluate them annually when looking at the benefits.
The bottom line on stock buybacks
As an investor, it’s important to understand what a stock buyback is and how it can affect a company’s share prices. A company can have different motives, both positive and negative, for investing money back in itself by buying up shares.
Buybacks tend to increase a stock’s value because they decrease the available number of shares. They can also offer a tax-advantaged alternative to dividends when it comes to returning wealth to shareholders.
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