A stock buyback occurs when a company buys outstanding shares of its own stock with excess cash or borrowed funds. This reduces the total number of shares available; it also increases the value of the shares that remain.
Learn how and why companies do stock buybacks, the different types of buybacks, and whether buybacks are good for investors.
The CARES Act prohibits stock buybacks for companies that received CARES Act loans or loan guarantees. It blocks companies from using relief money to fund stock repurchases. The ban extends for 12 months after the loan is paid off.
What Is a Buyback?
Individuals and institutions buy shares of stock in a company to see their investment grow through appreciation in the stock price or dividends. Another way for a company to return value to its investors is through stock buybacks.
In a stock buyback, a company buys shares of its own stock. Then, it either permanently removes them from circulation or retains them for resale to the market in the future. Decreasing the total shares of stock outstanding increases the ownership stake that each remaining share of stock represents; this increases the value for shareholders.
- Alternate name: Share repurchase
How Do Buybacks Work?
Stock buyback plans are often proposed by executives and authorized by a company’s board. But announcing a planned buyback does not always mean it will occur. In some cases, the target share price a company selects may not be met, or a tender offer may not be accepted.
Companies may initiate buybacks to prevent a third party from taking ownership of a controlling share of a company’s stock.
An Example of a Stock Buyback
Let's say a company has 100,000 shares of stock outstanding at $50 per share for a market capitalization of $5 million. The company has a few good years in a row, but its stock price remains flat and does not reflect that growth. Executives may feel the stock is undervalued. They decide to initiate a stock buyback.
The executives use $1 million of cash from net profits to purchase 20,000 shares at the same $50 per share price. This decreases the total outstanding shares to 80,000. Each share no longer represents the 0.001% ownership it did when there were 100,000 available shares. Instead, it represents 0.00125%; this is a 20% increase in value per share.
Types of Buybacks
There are two types of buybacks: open market and tender offer.
Companies may repurchase shares on the open market at prescheduled times or when management feels it is the best use of capital.
In a tender offer, the company offers to buy back its shares. This is often at a higher price than what the shares cost on the open market. All tender offers are subject to regulation by the Securities and Exchange Commission (SEC).
A tender offer may also come from a third party looking to gain a controlling share of the company. In this case, the transaction is a third-party tender offer and not a buyback.
Alternatives to Buybacks
Stock buybacks are just one way a company can use capital to increase shareholder value. Other options include:
- Returning cash on hand to investors in the form of dividends
- Reinvesting capital in research and development
- Using capital to acquire securities or other companies
Alternatives are an important part of understanding buybacks; buyback programs have come under scrutiny in the past few years.
Buyback Criticism and Drawbacks
Companies are often criticized for share repurchases. Some have argued that firms repurchase shares to meet short-term goals at the expense of long-term ones.
Another drawback is that companies open up vulnerabilities when they go into debt to purchase stock. The move may be costly if a company repurchases shares at a price that proves to be overvalued. There is also some concern that decisions to repurchase shares are often made to enrich corporate executives. At the same time, it may slow stock growth rates and create long-term declines in earnings for workers.
Shareholders could take issue with buybacks, too; they may prefer dividends over buybacks. That way, they can control how their returns are reinvested. They can purchase their own additional shares through a dividend reinvestment plan (DRIP). Or, they can put the cash to work in some other fashion.
Buybacks vs. Dividends
A dividend payment represents cash in hand for an investor or more shares of a stock for those who reinvest dividends. A share buyback provides no immediate return to an investor. But it could prove to increase the company’s value while deferring tax consequences.
|Returns||Increases share value through increased earnings per share.||Provides real return through cash or additional shares of stock.|
|Taxes||Taxed as ordinary income if you held the stock for less than a year. Taxed as long-term capital gains if held for at least a year, but those making less than $80,000 may not pay any taxes.||Often taxed as ordinary income, resulting in higher tax rates compared to capital gains taxes.|
|Investor liquidity||Locks investors into the fortunes of the company.||Provides investors the option to use the cash as income or invest somewhere else.|
Stock repurchasing and dividends are often seen as competing options. But companies can use both to offer value to investors.
“We actually think that dividends vs. share buybacks is something of a false dichotomy,” Morningstar strategist Dan Lefkovitz said in a company video about buybacks. “The fact is that many companies these days do both… Share buybacks have become a lot more prominent and have, in fact, eclipsed dividends as a means of returning cash to shareholders.
What a Buyback Means for Individual Investors
Whether a share buyback is good or bad for individual investors is not a simple question. Many variables factor into the answer: the share price at the time of purchase, whether better investment options exist, and whether an investor prefers dividends.
- A stock buyback occurs when a company buys outstanding shares of its own stock with excess cash or borrowed funds.
- A buyback increases the value of outstanding shares; it reduces the number of total shares on the market, which increases the earnings per share (EPS).
- One alternative is to paying dividends to investors. This can be in the form of cash or additional shares of stock.
- A poorly timed buyback, like when the share price is overvalued, may prove detrimental.