3 Reasons Companies Choose Stock Buybacks

Reviewed by David KindnessFact checked by Vikki VelasquezReviewed by David KindnessFact checked by Vikki Velasquez

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

Companies commonly raise equity capital through common and preferred shares. However, a company may repurchase its shares to reduce the cost of capital, consolidate ownership, preserve stock prices, and boost its key financial ratios. Share buybacks are a way to return cash to shareholders instead of through dividends.

Key Takeaways

• Companies choose buybacks for company consolidation, equity value increase, and to appear financially attractive.
• Buybacks are typically financed with debt, which can strain cash flow.
• Stock buybacks may affect the overall economy.

1. Consolidate Ownership

Each share of common stock represents a stake in the ownership of the issuing company, including the right to vote on the company policy and financial decisions. A company with one managing owner and one million shareholders has 1,000,001 owners. A buyback reduces the number of owners, voters, and claims to capital.

Common 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.

Important

In 2023, The value of U.S. companies’ repurchased shares totaled $773 billion.

2. Reduce Costs and Increase Equity Value

Shareholders earn returns in the form of dividends, a cost of equity. 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. However, a company might cut its dividends to preserve cash if the economy slows. The result would lead to a sell-off in the stock. By buying back fewer shares, and achieving the same preservation of capital as a dividend cut, the stock price would likely take less of a hit.

A company may also choose buybacks if its shares are undervalued. Undervaluation can occur due to investors’ sentiment on short-term performance, a sensationalist news item, or a general bearish market. 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 additional shares.

Assume a company issues 100,000 shares at $25 per share, raising $2.5 million in equity. An ill-timed news item questioning company leadership may cause shareholders to sell, driving the price down to $15 per share. The company may repurchase 50,000 shares at $15 per share for $750,000. Suppose events turn around for the business, driving the stock price to $35. If the company reissues the 50,000 shares at the new market price, it has a capital influx of $1.75 million. Because of the brief undervaluation, the company turned $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).

Note

A repurchase and reissue can prove risky if prices stay low. However, it can enable businesses with a long-term need for capital financing to increase their equity without further diluting company ownership.

3. Appear Financially Healthy

Buying back stock can help a business look more attractive to investors. Investors may see that a buyback means a company is financially healthy, no longer needs excess equity funding, and is confident to reinvest in itself. By reducing the number of outstanding shares, a company’s earnings per share (EPS) ratio is increased because its annual earnings are now divided by a lower number of outstanding shares.

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.

Short-term investors often look to make quick money by investing in a company leading up to a scheduled buyback. The 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.

Disadvantages 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. Credit reporting agencies view 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.

As of 2023, stock buybacks by publicly-owned companies are subject to a 1% excise tax under specific conditions including:

• The tax does not apply if the repurchases exceed $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 fiduciary companies are exempt from the excise tax.
• The tax is not deductible.

How Do Stock Buybacks Affect the Economy?

Stock buybacks can have a mildly positive effect on the economy as they may lead to rising stock prices. Research has shown that increases in the stock market positively affect consumer confidence, consumption, and major purchases, a phenomenon dubbed “the wealth effect.”

What Makes a Buyback a Positive Growth Strategy?

Share buybacks are generally less risky than investing in research and development for new technology or acquiring a competitor. It can be profitable 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.  

What Does a Stock Buyback Do?

A share repurchase takes outstanding shares off the market and returns capital to investors.

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. There are drawbacks to stock repurchases, such as possible taxes on the buybacks, a reduction in credit rating, or loss of investor confidence.

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