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Unpacked: Stock buybacks
Stock buybacks are a popular strategy among companies looking to use excess cash, boost their stock price and reward shareholders. But how exactly does the process work, and are there any drawbacks? Find out more.
Unpacked: Stock buybacks
Companies sell shares on the stock market to raise capital, but some do the opposite and repurchase these shares for themselves, a process known as stock buybacks. Why do companies want their own shares back? And what does this mean for investors? This is Stock Buybacks: Unpacked.
Stock buybacks can be carried out in two ways. First, let's look at the tender offer. This is a scenario where shareholders are invited to sell their shares directly back to the company at a fixed price, which is usually higher than the market price. Alternatively, companies can buy back their own shares on the open market at the same price that anyone else would pay. This gives them more leeway to repurchase the shares they want when they want them.
So why do companies do this? A company might buy back stock that it feels is undervalued or diluted. For example, share dilution can happen when a company issues new stock to employees. By repurchasing some of its own shares and then canceling those shares, the company reduces the total number of outstanding shares on the market. As stock prices are largely based on supply and demand, this can drive up the value of the remaining shares.
An additional benefit of buybacks is that they can be used to return cash to investors. This is in many cases more tax efficient than paying out dividends. Plus, with fewer shares in circulation, each shareholder gets a bigger stake in the company. However, to reduce the tax disparity between buybacks and dividends, the U.S. government recently added a 1% tax to stock repurchases.
On the other hand, stock buybacks can have downsides for shareholders. By inflating the value of a company's stock, buybacks might mask its true earnings per share. Also known as EPS, executives can also benefit disproportionately from buybacks if their pay package includes lots of stock compensation. What's more, stock buybacks might not be the best use of cash.
Shareholders might rather see the company investing its money back into the business. Buybacks might therefore hint that a company doesn't have strong growth prospects, which investors could take as a negative sign.
Despite these downsides, share buybacks still remain widespread. Today, they continue to be a popular strategy among companies looking to use excess cash, boost their stock price, and reward shareholders.
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