Dividend payments are a common way for profitable public firms to give their shareholders more money. However, they also have another option for rewarding their investors: share buybacks, commonly known as stock buybacks or share repurchase schemes.
A Stock Buyback: What Is It?
When a publicly traded firm uses funds to acquire shares of its stock on the open market, this is known as a stock buyback. A business could take this action to give shareholders money they don’t need to pay back for operations and other investments.
A “repurchase authorization,” Public companies that have chosen to perform a stock buyback usually declare the amount of money that will be put aside to buy back shares or the number of shares or percentage of outstanding shares that it wants to buy back.
Why Do Businesses Repurchase Their Stock?
Companies typically repurchase their shares to increase value for their shareholders. Value in this context refers to an increasing share price.
The price of a company’s stock increases if there is a demand for its shares, as explained below. A corporation that purchases its own stock adds value for all of its shareholders by driving up its stock price through increased demand.
Several ways that share buybacks can benefit investors include:
- Repurchases provide cash back to investors who wish to sell their stock.
- All other things being equal, the corporation can raise earnings per share through a repurchase. A higher portion of the profits is represented by the same earnings pie divided into fewer pieces.
- Buybacks improve the stock’s potential upside for shareholders who wish to hang onto their shares by lowering the share count. Each share is worth more if the corporation has a $1 billion market value but is divided into fewer shares.
- Compared to dividends, which are taxable to the recipients, they are a more tax-efficient way to distribute the company’s profits to shareholders.
Pitfalls Of A Stock Buyback
The following are some of the most usual arguments opposing buybacks:
- Buybacks may be used to mask the issuing of stock to management. When a corporation pays managers using stock, it dilutes shareholders’ ownership. Some management teams employ buybacks to hide the extent to which issuance influences share count.
- Buybacks may be executed incorrectly. For example, a management team may be squandering shareholder money if it purchases the stock at any price rather than at a fair price. Therefore, it devalues a stock if a management team buys it for $150 while its actual value is just $100.
- Buybacks may deprive the company of funds needed for other purposes, such as R&D or investments in new equipment and facilities.
Buybacks have the potential to considerably increase investors’ returns, primarily when pursued over the long term. In addition, certain shareholders adore top executives who utilize them effectively as a strategy.
The pros and cons of stock buybacks mostly rely on who is conducting them, when, and why. Repurchasing shares while neglecting other objectives is most likely a massive mistake that will cost shareholders in the long run. On the other hand, stock buybacks may both produce and destroy value.