A stock buyback occurs when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously distributed among public and private investors.

When a company repurchases its shares, it can purchase the stock on the open market or from its shareholders directly. In recent decades, share buybacks have overtaken dividends as a preferred way to return cash to shareholders. Though smaller companies may choose to exercise buybacks, blue-chip companies are much more likely to do so because of the costs involved.

Reasons for Stock Buybacks

Because companies raise equity capital through the sale of common and preferred shares, it may seem counter-intuitive that a business might choose to give that money back. However, there are several reasons why it may be beneficial for a company to repurchase its shares, including reducing the cost of capital, ownership consolidation, preserving stock prices, undervaluation, and boosting its key financial ratios.

Stock Repurchases Reduce Costs

Each share of common stock represents a small stake in the ownership of the issuing company, including the right to vote on the company policy and financial decisions. If a business has a managing owner and one million shareholders, it actually has 1,000,001 owners. Companies issue shares to raise equity capital to fund expansion, but if there are no potential growth opportunities, holding on to all that unused equity funding means sharing ownership for no good reason.

Many shareholders demand returns on their investments in the form of dividends, which is a cost of equity—so the business is essentially paying for the privilege of accessing funds it isn’t using. Therefore, buying back some or all of the outstanding shares can be a simple way to pay off investors and reduce the overall cost of capital. For this reason, Walt Disney (DIS) reduced its number of outstanding shares in the market by buying back 73.8 million shares, collectively valued at $7.5 billion, in 2016.

Stock Buybacks Consolidate Ownership

Companies issue shares to raise funding for projects. Several types of shares can be issued, but the two most popular are common and preferred shares. Common—also called ordinary—shares come with voting privileges and ownership. Preferred shares differ in that dividends are paid out to the shareholders before common shareholders, and these shareholders are higher in the queue for payout during a bankruptcy proceeding.

A company with thousands of stocks issued essentially has thousands of voting owners. A buyback reduces the number of owners, voters, and claims to capital.

Stock Buybacks Preserve the Stock Price

Shareholders usually want a steady stream of increasing dividends from the company. And one of the goals of company executives is to maximize shareholder wealth. However, company executives must balance appeasing shareholders with staying nimble if the economy dips into a recession. 

Why do some favor buybacks over dividends? If the economy slows or falls into recession, a company might be forced to cut its dividends to preserve cash. The result would undoubtedly lead to a sell-off in the stock. However, if the bank decided to buy back fewer shares, achieving the same preservation of capital as a dividend cut, the stock price would likely take less of a hit.

Committing to dividend payouts with steady increases will undoubtedly drive a company’s stock higher, but the dividend strategy can be a double-edged sword. In the event of a recession, share buybacks can be decreased more easily than dividends, with a far less negative impact on the stock price.

The Stock Is Undervalued

Another major motive for businesses to do buybacks is that they genuinely feel as if their shares are undervalued. Undervaluation occurs for several reasons, often due to investors’ inability to see past a business’ short-term performance, sensationalist news items, or a general bearish sentiment. For example, a wave of stock buybacks swept the United States in 2010 and 2011 when the economy was recovering from the Great Recession.

Many companies began making optimistic forecasts for the coming years, but company stock prices still reflected the economic doldrums that plagued them in years prior. These companies invested in themselves by repurchasing shares, hoping to capitalize when share prices finally began to reflect new, improved economic realities.

If a stock is dramatically undervalued, the issuing company can repurchase some of its shares at this reduced price and then re-issue them once the market has corrected, thereby increasing its equity capital without issuing any additional shares. However, investors may be reluctant to purchase the re-issued shares if they feel they’ve been burned by a company this way.

For example, assume a company issues 100,000 shares at $25 per share, raising $2.5 million in equity. An ill-timed news item questioning the company’s leadership ethics causes panicked shareholders to begin to sell, driving the price down to $15 per share. The company decides to repurchase 50,000 shares at $15 per share for a total outlay of $750,000 and wait out the frenzy.

The business remains profitable and launches a new and exciting product line the following quarter, driving the price up past the original offering price to $35 per share. After regaining popularity, the company reissues the 50,000 shares at the new market price for a total capital influx of $1.75 million. Because of the brief undervaluation of its stock, the company was able to turn $2.5 million in equity into $3.5 million without further diluting ownership by issuing additional shares ($2.5 million – $750,000 = $1.75 million + $1.75 million = $3.5 million).

Stock Buybacks Adjust the Financial Statements

Buying back stock can also be an easy way to make a business look more attractive to investors. By reducing the number of outstanding shares, a company’s earnings per share (EPS) ratio is automatically increased—because its annual earnings are now divided by a lower number of outstanding shares. For example, a company that earns $10 million in a year with 100,000 outstanding shares has an EPS of $100. However, if it repurchases 10,000 of those shares, reducing its total outstanding shares to 90,000, its EPS increases to $111.11 without any actual increase in earnings.

Also, short-term investors often look to make quick money by investing in a company leading up to a scheduled buyback. The rapid influx of investors artificially inflates the stock’s valuation and boosts the company’s price-to-earnings ratio (P/E). The return on equity (ROE) ratio is another important financial metric that receives an automatic boost.

One interpretation of a buyback is that the company is financially healthy and no longer needs excess equity funding. The market can also view that management has enough confidence in the company to reinvest in itself. Share buybacks are generally seen as less risky than investing in research and development for new technology or acquiring a competitor; it’s a profitable action as long as the company continues to grow. In addition, investors typically see share buybacks as a positive sign for appreciation in the future. As a result, share buybacks can lead to a rush of investors buying the stock.  

Downside of Stock Buybacks

A stock buyback affects a company’s credit rating if it borrows money to repurchase the shares. Many companies finance stock buybacks because the loan interest is tax-deductible. However, debt obligations drain cash reserves, which are frequently needed when economic winds shift against a company.

For this reason, credit reporting agencies view such-financed stock buybacks negatively: They do not see boosting EPS or capitalizing on undervalued shares as a justification for taking on debt. A downgrade in credit rating often follows such a maneuver.

Starting January 2023, stock buybacks by publicly-owned companies will be subjected to a 1% excise tax under specific conditions. Some of the conditions that apply are:

• The tax does not apply if the repurchases are less than $1 million.
• New issues to the public or employees reduce the taxable amount of stocks repurchased.
• If the repurchase is treated as a dividend, the tax does not apply.
• Real estate investment trusts and regulated investment companies are exempt from the excise tax.
• The tax is not deductible.

Stock Repurchase Effect on the Economy

Despite the above, buybacks can be good for a company. How about the economy as a whole? Stock buybacks can have a mildly positive effect on the economy overall. They tend to have a much more direct and positive impact on the financial markets, as they lead to rising stock prices.

But in many ways, the stock market feeds into the real economy and vice versa. For example, research has shown that increases in the stock market positively affect consumer confidence, consumption, and major purchases, a phenomenon dubbed “the wealth effect.”

Another way improvements in the financial markets impact the real economy is through lower borrowing costs for corporations. In turn, these corporations are more likely to expand operations or spend on research and development. These activities lead to increased hiring and income, and fuel improvements in the household balance sheet. Additionally, they increase the chances that consumers can leverage up to borrow to buy a house or start a business.

The Bottom Line

A company repurchases its shares when it wants to consolidate ownership, preserve stock prices, return stock prices to real value, boost financial ratios, or reduce the cost of capital.

Investors can benefit from stock buybacks because the practice has generally taken the place of dividends. However, there are business drawbacks for stock repurchases, such as possible taxes on the buybacks, a reduction in credit rating, or loss of investor confidence.