The Benefits of Stock Buyback Programs

The Golden Egg of Shareholder Value

Close up of stock certificate
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Occasionally, a company will choose to buy back shares of its stock in a process referred to as a stock buyback program. When this happens, a company pays the market price for the shares, retains ownership, and increases the ownership stake of the remaining stockholders

How the Stock Buyback Program Works

Let's imagine a candy company has 100,000 shares outstanding that are valued at $50 each, giving them a market capitalization of $5,000,000. Management is upset because the company only made $1,000,000 in profits this year, which is exactly the same as last year. That means the growth rate is zero. The executives want to do something to make the shareholders money because of the disappointing performance this year, so they consider a stock buyback program: The company will use the $1 million profit it made this year to buy 20,000 shares of stock in itself. They take the shares to the Board of Directors, where they vote to destroy them—bringing the candy store's total amount of shares outstanding down to 80,000.

This means each share you own no longer represents the 0.001% ownership it originally did when there were 100,00 shares outstanding. Instead, it represents 0.00125%, which is a 20% increase in value per share.

The Benefits of Stock Buyback Programs

The primary advantage of buyback programs is that an investor's shares become more valuable and represent a greater percentage of equity in the company. Earnings per share (EPS) is a critical measure that investors examine before deciding to purchase a stock. A buyback program announcement will generally cause a stock's price to rise in the short-term because investors know decreasing the number of shares outstanding causes a company's EPS to increase. For businesses, stock buyback programs help replace equity financing with debt financing, which is often more cost-efficient. It also allows businesses to benefit from the undervaluation of their shares.

A Potential Pitfall

Even though buybacks can be sources of long-term profit for investors, they are harmful if a company pays more for its stock than it is worth. In an overpriced market, it would be foolish for management to purchase equity at all, even in itself.

Instead, the company should put the money into assets that can be easily converted back into cash. This way, when the market swings the other way and is trading below its true value, shares of the company can be repurchased at a discount—ensuring current shareholders receive maximum benefit. Remember, even the best investment in the world isn't a good investment if you pay too much for it.

Possible Public Relations Backlash

Share buybacks are not always met with rousing applause. While they can make investors happy, there is always a risk that the public (and some investors) will question why profits are being spent to boost shareholder value instead of being invested back into the company or paying workers more money. Some companies will choose not to buy back shares simply to avoid bad publicity.