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The pluses and minuses of stock buybacks

They may benefit shareholders but can also be used to manipulate company financials.

Stock buybacks are controversial — and for good reason. While they may serve as an opportunity for businesses to give back to shareholders, they also hold the potential for abuse from company executives.

What is a stock buyback?

A stock buyback occurs when a company buys back its shares from the marketplace. Buybacks are essentially a form of investing, but instead of shareholders backing a company, the company elects to reinvest in itself. Buybacks can also serve as an opportunity for companies to give back to shareholders since fewer outstanding shares on the market increases the value of each share along with the ownership stake for individual investors holding the stock.

Buybacks are also called share repurchasing. They can help companies consolidate ownership, increase equity capital, correct undervalued stock and improve financial ratios.

Stock buyback example

Company X decides it wants to buy back some of its stock. It doesn’t have any ambitious expansion or growth projects on the horizon and wants to consolidate ownership and reduce the overall cost of capital by taking back some outstanding shares.

Before the stock buyback, Company X has $20 million in assets and yearly earnings of $2 million. With one million outstanding shares on the market, Company X’s earnings per share (EPS) sits at $2 per share.

Using cash assets, Company X buys 500,000 of its outstanding shares at the going market rate of $5 per share. The buyback costs Company X a total of $2.5 million and reduces its outstanding share count to 500,000. With fewer shares on the market, Company X has now increased the sliver of ownership held by individual shareholders and increased its earnings per share to $4 per share.

Are buybacks good for investors?

They can be. Stock repurchases increase ownership stakes for existing shareholders. For example, if you own 1 share of a company with 100 shares on the market, your share represents a 1% slice of that company’s ownership pie. Now, let’s say that company buys back 20 of its shares and reduces its share count to 80. Your single share now represents a 1.25% ownership stake.

A well-timed buyback can also help shareholders by rebalancing undervalued shares or by protecting the stock from unruly market fluctuations. Share repurchasing can also improve the price of the stock by creating a supply shock — fewer shares may increase demand and cause the stock’s price to rise.

But corporate buybacks can also be dangerous — for shareholders and the company. Buybacks are controversial, as they can be used to benefit executive stakeholders, manipulate share prices and artificially inflate financial ratios to make a company seem more profitable than it is.

And if the company borrows money to execute the buyback and share prices stay low? Not only does the company sacrifice its credit rating but it also puts its cash reserves at risk.

Why do companies buy back stock?

There are a number of reasons companies buy back stock — some designed to benefit the shareholder and others with the intent of bolstering the company.

Consolidate ownership

Every outstanding share represents a slice of ownership in a company, and this ownership can be accompanied by the right to vote on the company policy and financial decisions. With fewer shares on the market, a company can effectively reduce the number of people it needs to answer to. This may be an especially important strategy for companies that want to funnel power into the infrastructure of their core leadership.

Reduce the cost of equity

Companies issue shares to raise money — typically to fund company expansion. But if a company has already grown to command a significant slice of its industry, there may be fewer opportunities to pursue — and less need for investor capital.

The issue is that company shareholders expect a return on their investment, typically in a form of a dividend. If the company isn’t making use of its equity funding and has to steadily shell out dividends on shares, it’s essentially burning money on unused equity. Share buybacks allow companies to reduce the cost of equity by taking back a portion of outstanding shares.

Correct undervalued stock

If a company believes that its stock is undervalued, it can buy back some low-priced shares and hold them until the price rises to sell at a profit. The same strategy can be used to weather poor market conditions: a company buys back its stock, waits for the market to recover and releases the shares once market conditions are more favorable.

Reduce dilution

A company may also engage in a stock buyback to reverse the dilution that may occur when employees exercise their stock options. When they do that, the number of the company’s outstanding shares goes up. This means existing stockholders now owe a smaller percentage of all outstanding shares. That makes shares less valuable. It also lowers the company’s earnings per share. So dilution can negatively affect the image of the company’s financials. To reverse this trend, companies may buy back stocks to reduce the number of outstanding shares.

Improve financial ratios

One of the reasons stock buybacks draw criticism is their potential for abuse — specifically, when companies use them to manipulate their price to earnings ratio (P/E), return on equity (ROE) and earnings per share.

Buybacks deplete outstanding shares and typically increase a company’s EPS: one of the key metrics investors use to gauge the financial health and viability of an investment opportunity. But here’s the problem: a higher EPS as a result of a buyback isn’t actually increasing the company’s fundamental value because cash is required to purchase shares.

An EPS boost following share repurchasing is typically short-lived. And while even a temporary EPS increase has the ability to prop up share prices, this artificial lift may only serve to mask a company’s true financial ratios.

Protect from hostile takeover

Stock buybacks may help a company protect itself from hostile takeovers — a process through which an acquiring company attempts to take over a target company against its wishes.

Let’s say Company A wants to acquire Company B. As part of its hostile takeover strategy, Company A plans to approach Company B shareholders to offer them a premium for their ownership stake in the company. To prevent a takeover and discourage Company A from approaching its shareholders, Company B executes a stock buyback.

The stock buyback has the potential to protect Company B in two ways. First, it may raise the price of remaining shares, making it more expensive for Company A to purchase. Second, it will likely add a large sum of debt to the company’s balance sheet since it can cost millions to repurchase shares, making Company B all the more undesirable.

How do companies conduct stock buybacks?

There are two ways for businesses to execute stock buybacks:

  • Tender offer. Companies approach shareholders and make a tender offer to buy back individual shares, sometimes offering a premium to help incentivize the offer. Investors aren’t obligated to accept, but can opt to sell back their shares if the offer aligns with their investment goals and time horizons.
  • Open market. Companies purchase available shares from the open market at the current market price of the stock.

What do companies do with buybacks?

Once a business has repurchased its shares, it can do one of two things: it can keep the shares as treasury shares or it can cancel them outright.

Treasury shares aren’t included in earnings-per-share calculations, don’t issue dividends and have no voting rights. Treasury stock is listed on a company’s financial statements and can be reissued through stock dividends, employee packages and on the public market to raise capital.

Cancelled shares, or retired shares, are just what they sound like — shares that have been permanently revoked and are not eligible to be reissued at a later date.

What a business chooses to do with its shares after a buyback depends on why they were repurchased in the first place. If it’s attempting to rehabilitate the value of its stock, it may want to keep its shares as treasury shares so that they can eventually be reissued. But if it’s attempting to consolidate ownership or reduce the cost of equity, it may prefer to cancel the shares outright.

Are stock buybacks illegal?

Not anymore. But they were banned up until 1982 under the Securities and Exchange Act of 1934, which considered buybacks to be a form of stock manipulation.

In 1982, the U.S. Securities and Exchange Commission passed rule 10b-18, which made corporate buybacks legal under two conditions. First, that companies purchased no more than 25% of their average daily volume over the previous four weeks. And secondly, that they didn’t buy back their stock at the beginning or end of the trading day.

That said, the recent $2.1 trillion CARES Act has placed a ban on stock buybacks for any large corporations that receive loans or loan guarantees under the legislation. The buyback ban continues to apply for 12 months following full repayment of the loan. In addition to banning stock buybacks, the CARES Act also forbids companies that receive funding from issuing dividends or raising the pay of its executives.

Stock buyback alternatives

For a company looking to give back to shareholders, improve its stock or invest in itself, there are a few alternatives to buybacks:

  • Stock dividend. If a company wants to reward its shareholders, it can regularly distribute money to shareholders through a cash dividend.
  • Acquire another company. For a business with extra cash on hand looking to grow, acquiring another company or expanding to new locations is an option.
  • Invest in research and development. Instead of spending money to snap up its own stock, a business can opt to reinvest that cash in research and development.

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Bottom line

Stock buybacks can be used for a variety of purposes. Some buybacks are executed with the intention of benefiting shareholders — others have been criticized as a method of stock manipulation.

Carefully vet the companies you invest in and review your brokerage account options to find the platform that can best serve your investment strategy.

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