At its core, the term “stock buyback” simply refers to the repurchasing of shares of stock by the company that issued them. In other words, this happens when the issuing company pays shareholders the market value per share and re-absorbs a portion of equity that had previously been held by outside investors. Further, this generally occurs in one of two ways: 1. The company can buy their shares back on the public market, or 2. The company can directly buy equity back from individual investors.
While you now have a basic understanding of stock buybacks, there might be a lingering question on your mind; Why would a company want to buy back its own shares? This is a great question! Since the goal of selling common (and preferred) stock is to raise capital, it comes across as counter-intuitive to buy it back, right? On the surface, this might appear true, however, there are multiple reasons that conducting a buyback might be beneficial to a company. To demonstrate this, below is a breakdown of two of the most significant: undervaluation and the practice of enhancing financial ratios.
Typically, we only look at undervaluation as being negative for a company. In reality, though, there are ways that a company can strategize and use its undervaluation for-profit —stock buybacks being a prime example. To understand this, it is important to remember that there are many reasons that a stock might be undervalued. For instance, there might be a particularly significant news story that has affected the company’s image. Likewise, investors may simply overlook its long-term performance by only focusing on the short-term. Taking these scenarios into consideration, if a stock becomes immensely undervalued the company might be set up perfectly for a buyback. This is because the company could re-purchase their own shares at a discounted price and wait for the market (and its valuation) to correct before re-issuing. In doing so, the company will have raised its equity capital without choosing to issue any supplementary shares.
Enhancing Financial Ratios:
As you have probably come to learn from our other articles, investors tend to focus on different financial ratios (and matrices) when making investment decisions. As such, companies try to appear as attractive as possible to investors through their financials. Interestingly, stock buybacks can be used as a tool to improve these as well. For example, by buying back shares — therefore reducing the number of outstanding shares — a company’s earnings per share ratio will increase, consequently. Additionally, some investors who are focused on the short-term attempt to profit by investing in a company just before a scheduled buyback. The thought behind this is that the timely inflow of investors results in an inflated valuation — ultimately improving the company’s price to earnings ratio. As can be seen through these examples, stock buybacks can be of great value to companies when marketing to investors since they might make the company’s financials look better, therefore, making it look like a more attractive buy.
In summary, stock buybacks are a great example of a simple, yet effective, strategic play that an individual company can make. To the untrained person, the move might seem strange because of its nature, however, if used tactfully it can pay off tremendously. Finally, if a company is buying back its own shares investors might view the action as an indication of confidence. After all, a stock buyback is (in essence) the company reinvesting in itself. As such, it might be beneficial for you to pay attention to scheduled stock buybacks as you formulate your own investment plans. Who knows, maybe you will come across a scenario that works with your strategy and portfolio. Just keep in mind that conducting your own due diligence is extremely important before making decisions with your hard-earned money!