What Is a Stock Buyback and How Does It Work?

A stock buyback, also known as a share repurchase, occurs when a company acquires its own outstanding shares from the open market. This process involves the company using its capital to reduce the total number of shares publicly available. It serves as a direct way for a company to re-invest in itself.

Understanding Share Repurchases

When a company buys back its own stock, it effectively reduces the number of shares circulating in the market. This action lessens the supply of shares available to the public, which can influence the value of each remaining share. Repurchased shares can either be formally retired, taking them permanently out of circulation, or held by the company as “treasury stock.” Treasury stock represents shares that are issued but no longer outstanding, meaning they do not carry voting rights or receive dividends. This reacquisition directly impacts a company’s capital structure.

Motivations for Companies

Companies undertake share repurchases for various strategic reasons, often aiming to enhance shareholder value. One primary motivation is to return capital to shareholders, offering an alternative to traditional dividend payments. This method allows shareholders to potentially defer capital gains taxes until they sell their shares, unlike dividends which are typically taxed in the year received.

Another significant driver for buybacks is the potential to increase earnings per share (EPS). By reducing the total number of outstanding shares, a company’s net income is divided among fewer shares, thereby boosting the EPS figure. Companies may also initiate buybacks if their management believes the stock is undervalued by the market, signaling confidence in the company’s future prospects to investors. Buybacks can also help offset the dilutive effect of stock options or other equity compensation issued to employees, maintaining existing shareholders’ proportional ownership.

How Companies Execute Buybacks

Companies primarily utilize two main methods to execute share repurchases: open market repurchases and tender offers. The open market repurchase is the most frequently used method. In this approach, the company buys its shares gradually on a stock exchange over a period, similar to how any other investor would, offering flexibility in timing and volume. This method allows the company to purchase shares at prevailing market prices without paying a premium.

Alternatively, a company may employ a tender offer, which involves making a formal offer to shareholders to buy a specific number of shares directly from them. This offer typically specifies a predetermined price, often at a slight premium to the current market price, and sets a limited timeframe for shareholders to respond. Within tender offers, a company might use a fixed-price tender or a Dutch auction, where shareholders state their desired selling price within a range.

Impact on Financials and Shareholders

Share repurchases directly affect a company’s financial statements and can influence shareholder value. On the balance sheet, a buyback reduces the company’s cash reserves and simultaneously decreases shareholders’ equity by the amount spent on the repurchase. This reduction in assets and equity can, in turn, improve certain financial ratios, such as return on assets (ROA) and return on equity (ROE), as the denominator in these calculations decreases.

While buybacks do not directly impact the income statement’s revenue or expense lines, they significantly influence per-share metrics like earnings per share (EPS). The reduction in outstanding shares leads to a higher EPS, making the company appear more profitable on a per-share basis. For shareholders, this reduction in share count can lead to an increase in share price due to reduced supply and improved per-share metrics, effectively increasing their ownership stake in the company without additional investment.