Investments

How Does Stock Buyback Work

By David Krug David Krug is the CEO & President of Bankovia. He's a lifelong expat who has lived in the Philippines, Mexico, Thailand, and Colombia. When he's not reading about cryptocurrencies, he's researching the latest personal finance software. 8 minute read

Have you ever considered investing in a stock, woke up to find that it had soared overnight, only to learn that a stock buyback was the catalyst? In business and finance, this is a regular occurrence.

Market participants usually view share repurchases favorably, which leads to stock price increases. As a result, inexperienced investors often rush into the market following such events, but is this a wise course of action? What exactly are stock buybacks, and how do they affect the stock price both immediately and over the long haul?

What Are Stock Buybacks?

When a firm repurchases its own shares of stock on the open market, it is said to be engaging in a stock buyback. In other words, if Apple says it would buy back shares of its own stock, it suggests it intends to use part of its massive cash reserves to do just that.

When a firm buys back its own shares from stock market participants, investors often enjoy significant returns for a few reasons:

  • Stable finances. To have the financial wherewithal to purchase its own shares on the open market, a corporation needs to be in relatively good shape. Therefore, a share repurchase sends a strong signal to investors that the firm is doing well.
  • The administration is optimistic. There is no way that the management of a public firm would voluntarily buy back stock in anticipation of future difficulties. In this way, share repurchases convey optimism on the part of the company’s leadership.

The Repurchase Procedure

There are typically three phases involved in a share buyback:

  1. The Stock Buyback Has Been Announced by the Company. Before a firm buys its own stock on the open market, it will often publish a press release alerting investors to the impending purchase. The corporation may specify the number of shares it wants to buy back or the total amount of money it will allocate to the share buyback program, or it may simply state that it will be repurchasing shares at the open market price.
  2. When market conditions are favorable, the company will repurchase shares. With the intention of buying shares at the lowest feasible price, the business will wait for the optimal opportunity to conduct share repurchases after the announcement. The stock price at which the corporation buys shares varies with each separate transaction it does, reflecting the fluctuating nature of the market.
  3. After a successful share buyback program, the company has made the announcement. After the buyback program has been fully implemented, the business will announce the conclusion of the program through a press statement or a filing with the U.S. Securities and Exchange Commission (SEC). This document details the company’s share buyback program, including the total number of shares repurchased, the average price paid per share, and the current number of outstanding shares.

Do I have to resell my shares?

There is nothing you need to do if you are a shareholder in a firm that announces a repurchase; you will keep the shares you currently possess. The corporation will acquire shares from sellers in the open market during the repurchase program, just as an individual investor would.

The number of outstanding shares of stock is reduced when a business acquires a block of shares and doesn’t resell them. Current shareholders are under no obligation to sell their shares back to the corporation as part of a share repurchase scheme.

Why would a corporation purchase its own stock?

An understandable question that comes to the minds of new investors about a share repurchase is “why?” Several factors contribute:

  1. The company’s management believes the stock is undervalued.

The opinion by management that the stock is trading below its fair market value is a major motivating factor in a company’s decision to repurchase its shares. To enter bear market territory on the stock market is a regular occurrence during economic downturns.

The company’s plan is to repurchase its own stock at bargain prices in the hopes of reaping gains when the market eventually turns around. As the market improves, the firm may raise capital by selling its shares back into circulation at a profit.

Still, downturn markets aren’t the only time that companies repurchase their own shares. As a result of how frequently stocks are undervalued in the market, a distinct investment approach has developed: value investing.

  1. Increased Investor Demand is a result of share repurchases.

Investors are piqued when a firm buys back its own stock because it improves the appearance of the company’s financial health in the balance sheet and other reports. The number of shares issued is a factor in several value measures. Among the most crucial are:

  • Per-Share Profits (EPS). Earnings per share (EPS) is a key metric for investors to focus on when quarterly results are announced. This indicator is determined by analysts by dividing the net income for the reporting period by the number of shares outstanding.
  • Earnings Per Share Earnings per share (EPS) is the same as revenue per share. To better understand the true worth of publicly listed firms, many investors divide the company’s total income by the number of shares outstanding.
  • Per-Share Book Value is the same as Per-Share Book Value. By dividing the total net asset value by the number of outstanding shares, the book value per share statistic provides investors with a snapshot of the company’s net asset value on a per-share basis.
  • Shareholders’ Money Per Share. Finally, cash and equivalents are a crucial lifeline for publicly listed corporations in the eyes of investors. Therefore, the real worth of the firm may be calculated by dividing its cash and cash equivalents by the number of outstanding shares on the company’s balance sheet.

Each of these valuation techniques takes a financial indicator and divides it by the total number of shares in circulation to arrive at a value. Reducing the number of outstanding shares on the open market increases earnings per share (EPS), revenue per share (RepSp), book value per share (BVPS), and cash flow per share (CFPS) immediately upon each transaction.

  1. Cash in exchange for Votes

Companies that are open to the public sell stock in order to generate capital. That money, however, does not come cheap. The sale of stock grants investors a stake in the firm and provides them voting rights proportional to their part of the company’s total stock.

When a firm raises money from investors on the stock market, the executives have to give up some control over the company’s destiny. Therefore, management teams frequently repurchase stock to reclaim ownership of the business.

This is especially true when the firm’s founder simultaneously serves as the company’s chief executive, president, or chairperson when the company is repurchasing shares. It’s possible for a corporation to repurchase all of its outstanding shares and return to private ownership.

How a Share Repurchase Increases Shareholder Value

Companies that utilize their surplus cash to repurchase shares often benefit from the move, but shareholders also stand to gain from the practice. For several reasons, these deals benefit investors.

  1. Increased Investor Interest

As was previously said, share repurchases may boost financial indicators and boost a company’s valuation. Traders and investors alike will have a greater interest in the stock as a result.

Excellent news for the stock’s present owners. Supply and demand are the two partners in the stock market’s tango. When a company buys back its own shares, the number of outstanding shares on the market is reduced, which raises value measures. This causes more people to want to buy the stock, which, according to the law of supply and demand, drives up the price.

In the long run, the stockholders who had shares before the repurchase activity benefited from the price appreciation brought on by the increased demand for the company’s stock.

  1. Tax Advantages

Buying back shares of stock also offers advantages in the form of lower capital gains tax rates. The value is returned to owners on paper, but no actual dividends are paid out.

Investors who have owned their shares for less than a year must report dividend payments as earned income and pay taxes at their individual marginal rates. However, investors do not have to pay taxes on increases in the value of their stock portfolio until the time when they sell their holdings. Holding an investment for a year or more before selling it allows you to pay the reduced capital gains tax rate instead of your regular income tax rate on any profits.

Therefore, a corporation is eventually handing down a reduced tax burden connected with the investment when it decides to restore shareholder value through a share repurchase program rather than through dividend payments.

  1. A larger slice of the pie

Consider a publicly listed firm to be your go-to slice of pie at the holiday feast. If you have a favorite pie for dessert and there are unexpected guests, you can be sure that your slice will be cut smaller with each additional arrival.

Companies on the stock market may be thought of as pies, and the individual pieces of stock that represent those businesses as slices. When there are more shares issued and traded, each individual shareholder owns a smaller fraction of the corporation. When a corporation repurchases its own stock, it reduces the number of shares trading on the stock market, which raises the price of each remaining share.

Are There Any Drawbacks to Share Purchases?

There are several benefits associated with share buybacks for both publicly listed corporations and their investors. However, even the best restaurant occasionally turns out subpar food. It’s not always in the best interest of investors to do a share repurchase.

Instead of using existing cash reserves, many businesses opt to take out fresh loans to fund share repurchases. The benefit to the corporation is straightforward; it may deduct the interest it pays on the loan from its taxable income.

Financed share buybacks, on the other hand, are terrible for shareholders. Large amounts of debt are detrimental to investors since they eat away at capital over time. Therefore, businesses that take out loans to buy back stock typically see their credit scores drop as a result. When a company’s credit rating drops as a result of stock buybacks, the stock price usually follows suit.

Bottom Line

In general, share repurchase programs are beneficial to shareholders. They are valuable because they increase the wealth of current shareholders, lessen the burden of taxes, and boost demand for the stock through an enhanced balance sheet, all of which contribute to a rise in the stock price.

A firm’s participation in a share repurchase program isn’t always indicative of future performance and shouldn’t be used as the only factor in determining whether or not to invest in the company. These deals don’t always work out as planned, and can cause a decline in the worth of the firm and the value of investors’ shares.

Educated choices are always the most successful ones in the stock market. Before putting your hard-earned money at risk, it’s vital that you do your homework and fully comprehend the potential benefits and drawbacks of your investment.

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