Corporations with extra cash in the bank sometimes implement a stock buyback program, which allows the company to buy back shares of ownership from outside investors. These share repurchasing plans can have a dramatic effect on the company's operating strategy and brand image. Stock buyback plans also have an impact on individual and institutional investors, who often enjoy both short and long-term benefits from these plans.
One goal of every for-profit corporation is to maximize profit for the shareholders, or stockholders, as these investors are the owners of the company. When the company has excess cash beyond what it needed for daily operations and emergency reserves, this cash is considered to be largely wasted because it is not helping the company maximize profits. The company has several choices when it comes to handling excess cash, including paying a dividend to shareholders, investing the money in new equipment or assets, or buying back shares of the company. Depending on the company's goals and business plan, a stock buyback plan might make the most sense.
Types of Stock Buyback
Corporations have two basic choices for instituting a stock buyback program. They may make a tender offer, in which the company contacts current stockholders and offers to buy back shares, often at a premium price. Or the company can simply buy shares on the open market, paying the same market price investors do. Once the company buys these shares, it might hold them as treasury shares, which can be reissued in the future as needed, or it can choose to retire these shares for good.
Reasons for a Stock Buyback
There are many reasons companies set up a stock buyback programs. Often, these programs are put in place when the company feels that the stock is undervalued. This could be due to poor economic conditions overall, or an event linked directly to the company itself, such as an internal scandal. Buying back stock helps to reduce the overall supply on the market, which helps to increase its price. With fewer shares on the market, important financial figures such as earnings per share and return on assets automatically go up, which makes the stock more attractive to investors and can spur further demand, leading to further price increases. According to Minnesota Public Radio, stock buyback plans not only lead to short-term price gains, they are also associated with long-term price gains for many companies. Corporations may also initiate stock buyback plans to undo the effects of dilution. Dilution occurs when a company offers shares of stock to employees as a form of compensation. If this stock distribution plan is too generous, the company might have so many shares outstanding that the price-to-earnings ratio or other earnings figures is affected. Buying back these shares helps to undo the effects of dilution and improves artificially low financial ratios.
Stock Buybacks Vs. Dividends
Stock buybacks distribute excess cash to stockholders and are often seen as an alternative to dividends. Although dividends are typically seen as regular or ongoing cash payments, stock buybacks allow corporations to pass cash on to shareholders on a one-time basis. Issuing a dividend puts pressure on the company, as investors come to expect dividends to be paid each quarter or each year. By setting up a stock buyback program instead of paying dividends, the company can share cash with shareholders without setting a precedent that it would be expected to repeat regularly.
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