Corporations institute stock buyback programs to reduce the number of shares available for trading. A corporation normally executes a buyback program by repurchasing shares of its own stock at current prices in the open market. The usual effect of such programs is to boost the stock’s price, but this is subject to factors such as the size, speed and motivation for the buyback. If a stock is already overpriced, a buyback may not necessarily improve its price.
Common stock represents an ownership stake in a company. As such, it entitles stockholders to benefit from the company’s earnings, either through higher stock prices or dividends. Management can spend earnings on growing the company through new projects, new assets, paying down debt or other tactics. Unspent earnings accumulate in an account called “retained earnings,” the sole source of funds for dividends and one possible source of funds for stock buybacks. A corporation can also pay for a stock buyback program with debt -- this is called a “leveraged buyback.”
Earnings per Share
Earnings per share, or EPS, is the amount of net income earned in a period, usually a year, divided by the average number of outstanding shares for the period. Analysts and investors use EPS to evaluate the price of a stock. The price-to-earnings ratio, or P/E, establishes the relationship between stock price and earnings. Since buyback programs reduce outstanding shares, they result in a higher EPS and therefore a higher stock price, assuming the P/E ratio remains the same before and after the buyback program. However, other factors may call this assumption into question.
Corporations can borrow money to pay for a stock buyback program. The effect of a leveraged buyback depends on the amount of debt already owed by the corporation. As debt levels rise, more earnings must be spent on interest expense. High levels of debt are risky because a sudden drop in earnings could cause a company to default on its debt payments and trigger a bankruptcy. Stockholders naturally find such prospects extremely unattractive, and demand for the stock can drop, causing a price decline despite the buyback program.
Buybacks vs. Dividends
Normally, buyback programs compete with dividend payouts for retained earnings. Corporations have more flexibility with buyback programs -- they can curtail a buyback program without much publicity, hence with little impact on stock prices. Dividend cuts are always publicly reported and often hurt stock prices. Therefore, if a corporation is uncertain it can sustain either the current dividend payout or the current buyback program, it will protect dividends at the expense of buyback programs in order to help preserve the stock price.
If corporate management feels its stock is undervalued, it may push for a buyback program, especially if corporate bonuses are tied to stock prices. The effect of a buyback of underpriced stock is to reward the remaining shareholders at the expense of shareholders who sell their shares and thus fail to benefit from expected higher prices. However, if stockholders perceive the main purpose of a buyback is to enrich company management, they may dump their shares in quantities far beyond the limits of the buyback and thus drive down the stock price.
Eric Bank is a senior business, finance and real estate writer, freelancing since 2002. He has written thousands of articles about business, finance, insurance, real estate, investing, annuities, taxes, credit repair, accounting and student loans. Eric writes articles, blogs and SEO-friendly website content for dozens of clients worldwide, including get.com, badcredit.org and valuepenguin.com. Eric holds two Master's Degrees -- in Business Administration and in Finance. His website is ericbank.com.