What is a stock buyback? It is also called a share buyback, or a stock repurchase, and it is the reacquisition of stock by the company that issued it. Stock buybacks are usually an exchange of cash paid from a company to its shareholders, for a portion of the stock outstanding.
When a company cannot reinvest its retained profits to produce acceptable returns, either because the company has reached a mature size, there are no suitable acquisitions on the market or simply because the board of directors want to maintain the growth rate of the company, a stock buyback is considered a good way of returning value to shareholders indirectly, but is not usually used as a tool to manipulate share price.
The impact of share buybacks on share prices can vary depending on how much shares are rebought and how diluted the stock is. Ultimately though, the effect of stock buybacks on share price arise from changes in the company’s capital structure and more importantly, from the messages a buyback sends to the stock market. A buyback can indicate a conservative board of directors who, instead of making an unprofitable acquisition, decide to use excess cash to increase value for shareholders by increasing earnings per share (EPS).
Stock buybacks usually affect share prices in different ways depending on the current financial position of the company and the occurrence of recent events. For example, the buyback of publicly traded stocks is often thought to increase EPS ratio for investors, even if profit does not increase. With fewer shares in the market to divide profit over, the ratio rises. At first glance, this appears to have the effect of increasing share price, especially when a company’s share price is viewed as being undervalued.
However, this assumption does not always necessarily hold true, as demonstrated by Dell’s extension of its buyback program, Techforward, by an additional $10 billion in 2005. This announcement did nothing to slow the downhill movement of its share price, which was triggered by worries about the company’s operating results.
Experts argue that stock buybacks create no fundamental value aside from allowing managers to reach compensation-linked EPS goals. This is because an increase in EPS, which would normally be assumed to increase share value, would be accompanied bya concomitant reduction in the Price/Earnings (P/E) ratio.
A worked example for a company worth $1 billion and earning $90 million annually, with $200 million in cash reserves earning $10 million in interest and no other assets or liabilities, will serve to demonstrate this. If the company decides to buyback 18 million shares out of the 100 million outstanding shares at $12 a share, this effectively increases EPS from 1 to 1.09, but it also decreases P/E from 12 to 10.93. The return on invested capital holds steady at 9% even after the buyback.
This demonstrates that upon closer inspection, a stock buyback does not affect share price as the total company value falls in line with the decrease in the quantity shares.