What Is a Stock Buyback Program?

Stock buyback programs provide companies with an opportunity to not only reward current shareholders but also to simultaneously increase the value of their individual shares available for sale on the open market. Alongside dividend payments and general price appreciation, a buyback of shares is an effective method for influencing share value while simultaneously compensating shareholders for their investment and loyalty. Fortunately for investors, understanding the mechanics of a stock buyback program is relatively straightforward.

The Basics of a Stock Buyback Explained

If the term "stock buyback" is relatively unfamiliar, you may be more acquainted with the other name for this particular action, a "share repurchase." In either scenario, the actions being undertaken are virtually identical. A company that has issued shares on the open market invests available cash into the repurchase of a portion of these shares. When this occurs, the stocks that have been "purchased" by the company are simply reintegrated into the company's assets.

From an outside perspective, this simply means that the number of available shares for purchase on the market has decreased. With fewer shares available in the market, it is quite likely that the per-share value will increase, due in large part to the fact that the market capitalization of the company did not decrease in keeping with the reduction in the number of shares available.

For shareholders, a variety of options are presented when a stock buyback begins. For starters, investors can choose to relinquish their shares for cash at the buyback price issued by the company. The buyback price will almost always be above the current share value, making this particular option a profitable choice for shareholders. Those who do not wish to sell, however, can keep their shares in hopes of profiting from the decreased supply on the market.

Exploring the Mechanics of a Buyback

There are two possible means by which a company can begin repurchasing its shares: a tender offer and open market action. With a tender offer, the company re-purchasing their shares submits a notification to shareholders that they are interested and willing to repurchase a specific number of shares and the general price point at which they are willing to do so. At this point, an investor who believes that the tender offer is in their best interest can offer a specific number of shares at a specific price to the company.

The company will allow enough time to pass to receive a wide array of offers from interested shareholders before committing to a repurchase. It is in the company's best interest to purchase the shares they are seeking at the lowest price possible. With that in mind, they will likely sort through the proposals offered by shareholders to create the best possible combination of value and quantity.

A tender offer is not the only means through which to buy back shares, however. If a company chooses, they can simply begin to repurchase shares on the open market much like any normal investor. In this scenario, the company could gain access to available shares without offering a premium to current shareholders.

An open market repurchase is not without its drawbacks, however. As an example, it is important to note that it is not uncommon for a company's share price to increase in value significantly when a tender offer is announced. Because of this, companies may choose to avoid discreet purchases on the market in order to make a very public display of the buyback and hopefully generate profits during the process.

Motivation for a Share Repurchase

A company may choose to initiate a stock buyback program for a variety of reasons. One of the most often heard explanations for buyback programs issued by companies initiating the buyback is that the repurchase is the best possible use of capital at that moment in time. As part of their stated objective to maximize return for shareholders, a company's managerial personnel may believe that the buyback has the potential to significantly increase share value and deliver significant profits to investors. In the vast majority of scenarios, these reasons alone are more than enough to validate a stock buyback program.

A company may also choose to begin repurchasing its shares in anticipation of market volatility. For example, disappointing earnings reports, a weak economy and bad company PR are a handful of scenarios that could cause share prices to drop dramatically. In order to minimize the impact of such issues, a company may announce a stock buyback to help build momentum before bad news is made public or immediately afterward in order to regain momentum. In either scenario, a share repurchase could act as a defense tool to lessen the impact of other negative factors.

Financial Reporting and Share Buyback

Choosing to buy back shares can also be an excellent ploy in situations where a company is hoping to "rebrand" data associated with them in order to paint a more attractive portrait for potential investors. When a buyback is initiated, the number of assets on the corporate balance sheet is reduced in proportion to the size and scope of the action. Because of this, a stock buyback will actually increase the perceived return on assets, or ROA. Similarly, the reduction in outstanding equity occurring as part of the buyback will also increase the return on equity, or ROE, reported by the company.

Finally, and perhaps most importantly, a buyback can help improve a company's price-to-earnings ratio, also commonly referred to as the P/E ratio. Investors consider the lower P/E ratios to be a sign of an attractive investment. This is due to the fact that a lower P/E ratio implies that investors can receive a greater amount of earnings for a lower initial investment. With that in mind, a share repurchase could dramatically redefine these important metrics for potential investors and create an entirely new level of incentive for all involved.

Share Buyback and Dilution

In some scenarios, share buyback is considered a needed counter to the threat of dilution. When companies are forced to compete for labor and talent, it is not uncommon to offer generous stock options plans to attractive recruits. As a byproduct of an employee exercising their options, however, an increased number of shares enter the marketplace. Because of this, it is almost inevitable that the price per share decreases, if only due to the fact that there are now more shares available for trading than there were previously; this particular phenomenon is referred to as dilution.

As mentioned previously, a wide variety of critical data points are linked to the number of shares available on the marketplace. With that in mind, dilution could result in an increased P/E ratio and decreased ROA, as well as a decreased ROE. Ultimately, this could serve to dissuade future investors who may be actively comparing these metrics for a variety of potential stock picks.

In such a scenario, it is not uncommon for a company to initiate a stock buyback, if only to ensure that they "break even" with respect to the value of their stock. Essentially, a stock buyback could be the most effective strategy for mitigating losses rather than increasing profit.

Stock Buybacks on Undervalued Shares

A buyback program can be an excellent tool for boosting share value in situations where a company feels strongly that their shares are not being sold for their true value in the marketplace. Stocks can become undervalued for a variety of reasons, such as mediocre short-term performance or negative publicity.

In situations such and these, shareholders may make the decision to sell their stock out of fear or panic rather than practical analysis. The consequence of such actions will likely be a reduction in share value that does not match to the core fundamentals of the stock itself. In this scenario, a stock is said to be undervalued.

Although a stock buyback can help provide a significant boost to share value over the short term, there is no guarantee that these initiatives will keep stock prices elevated. For example, a company may issue a tender offer following a series of mediocre financial reports in hopes of boosting share price while overcoming their temporary decline. If the decline is not temporary, however, the tender offer or any other share repurchase action will not be able to stop a recurring decline in stock price. With that in mind, a stock buyback or share repurchase should never be considered its own complete long-term solution for raising share prices.

Credit and Share Repurchasing

Perhaps one of the most dangerous consequences of a share repurchase involves damage to a company's credit rating. If a company has to borrow money to pay for their own shares, long-term cash reserves will likely be affected negatively. This is due to the fact that these reserves will now be allocated not only to paying back the principal required to buy the shares but also the interest on the debt. With this in mind, credit ratings agencies can and will choose to downgrade a company's credit rating in situations where a significant sum of money is borrowed in order to complete a buyback program.

Because of this, corporate leadership will often carefully assess whether or not a stock buyback is the only tool available to them that they can use to offset declining share values. If other options present themselves, they may choose to utilize these in a bid to avoid the potential negative consequences of the buyback.

Whole Market Implications of Buybacks

When a company announces a buyback program, rising share prices that may occur as a byproduct of the offer generally have a positive impact on the market as a whole. With an increase in share prices also comes a variety of positive benefits, such as increased consumer confidence, consumer spending and more. Because of this, it could be said that stock buybacks generally have a positive, albeit somewhat indirect, effect on the market and the economy at large.

Although the size and scope of the buyback will play a large role in determining what kind of impact is truly made, there is typically some form of positive byproduct created by such actions. Investors should follow the marketplace carefully to identify upcoming buyback programs and determine whether or not it is in their best interest to participate.