When Does It Benefit a Company to Buy Back Outstanding Shares?

Investing News

When a company announces a stock buyback, it means that it intends to repurchase some or all of the outstanding shares it originally issued. In exchange for giving up ownership in the company and periodic dividends, shareholders are paid the stock’s fair market value at the time of the buyback.

A company may choose to buy back outstanding shares for a number of reasons. Repurchasing outstanding shares can help a business reduce its cost of capital, benefit from temporary undervaluation of the stock, consolidate ownership, inflate important financial metrics, or free up profits to pay executive bonuses.

Key Takeaways

  • Companies sometimes repurchase the shares that were initially issued to raise money.
  • A company may do so for a variety of reasons, including replacing equity financing for more cost-effective debt financing.
  • Companies may also use buybacks to take advantage of undervalued shares or to consolidate equity ownership.

Reduce Equity Financing Cost

The most generous interpretation of a company stock buyback is this: business is doing so well that it no longer needs as much equity financing to fuel its expansion plans.

Instead of carrying the burden of unneeded equity and the dividend payments it requires, a company’s management team may simply choose to buy existing shareholders out of their stakes. This, in turn, reduces the business’ average cost of capital.

That said, it’s important to remember that one of the key objectives of equity capital is to fund growth. So when a company volunteers to buy back stock from shareholders, it may be a sign that the business’ long term growth prospects aren’t as attractive as they once were.

Massive blue-chip companies, boasting an already firm foothold in their respective industries, often repurchase shares because expansion possibilities are limited.

A company stock buyback may be a sign that the core business is healthy and doesn’t need to rely as much on high-cost equity funding. On the other hand, it could mean that the company has no good expansion projects left to develop.

Capitalize on Undervalued Shares

A company buyback does not always signify that management has run out of uses for equity funding. In fact, share repurchases can be used as a strategic device aimed at generating even more proceeds without having to issue additional shares.

If management feels its stock is undervalued, it can choose to repurchase some or all of the outstanding shares at the deflated price and wait for the market to correct. When the stock price moves back up, the company can then reissue the same number of shares at the new higher price.

The result: total equity capital increases while the number of outstanding shares remain stable.

Consolidate Ownership

Stock buybacks are also used as a means of consolidating ownership. Each share of stock represents a small ownership stake in a company. The fewer outstanding shares, the fewer people management has to answer to.

Having fewer outstanding shares is also a simple way to inflate several important financial metrics; the same ratios used by analysts and investors to assess a given company’s value.

Earnings per share (EPS), for example, automatically increases as its denominator (number of shares) is reduced. Similarly, the return on equity (ROE) figure gets a leg up if shareholder equity is minimized while profits remain stable.

The truth is that buybacks are increasingly utilized as a way to boost executive compensation. Shareholder dividends are paid out of a company’s net profit. If there are fewer shareholders, the proverbial pie is divided into fewer pieces.

In addition, many corporate bonus programs are predicated on the business attaining certain financial goals. Common benchmarks include increased EPS and ROE ratios, as mentioned above. Repurchasing outstanding shares enables businesses to increase executive compensation by making the company appear more profitable.