When Does It Benefit a Company to Buy Back Outstanding Shares?

A company intends to repurchase some or all of the outstanding shares it originally issued when it announces a stock buyback. Shareholders are paid the stock’s fair market value at the time of the buyback in exchange for giving up ownership in the company and periodic dividends.

A company can choose to buy back outstanding shares for several reasons. Repurchasing outstanding shares can help a business reduce its cost of capital, benefit from temporary undervaluation of the stock, consolidate ownership, inflate important financial metrics, or free up profits to pay executive bonuses.

Key Takeaways

• Companies sometimes repurchase shares that were initially issued to raise money.
• A company might buy back shares for a variety of reasons including replacing equity financing for more cost-effective debt financing.
• Companies may also use buybacks to take advantage of undervalued shares or to consolidate equity ownership.
• Buybacks are sometimes used as a way to boost executive compensation.

Reducing Equity Financing Cost

The most generous interpretation of a company stock buyback is that a business is doing so well it no longer needs as much equity financing to fuel its expansion plans.

A company’s management team may simply choose to buy existing shareholders out of their stakes rather than carry the burden of unneeded equity and the dividend payments it requires. This reduces the business’s average cost of capital in turn.

One of the key objectives of equity capital is to fund growth, however, so it may be a sign that the business’s long-term growth prospects aren’t as attractive as they once were when a company volunteers to buy back stock from its shareholders.

Massive blue chip companies that are already boasting a firm foothold in their respective industries often repurchase shares because expansion possibilities are limited.

Important

A company stock buyback may be a sign that the core business is healthy and doesn’t need to rely as much on high-cost equity funding. It could also mean that the company has no good expansion projects left to develop, however.

Capitalize on Undervalued Shares

A company buyback doesn’t always signify that management has run out of uses for equity funding. Share repurchases can be used as a strategic device aimed at generating even more proceeds without having to issue additional shares.

Management can choose to repurchase some or all of the outstanding shares at the deflated price and wait for the market to correct if it feels that its stock is undervalued. The company can then reissue the same number of shares at the new higher price when the stock price moves back up. The result is that total equity capital increases while the number of outstanding shares remains stable.

Consolidating Ownership

Stock buybacks are also used as a means of consolidating ownership because each share of stock represents a small ownership stake in a company. The fewer outstanding shares, the fewer people management must answer to.

Having fewer outstanding shares is also a simple way to inflate several important financial metrics, the same ratios used by analysts and investors to assess a given company’s value. Earnings per share (EPS) automatically increases as its denominator, the number of shares, is reduced. The return on equity (ROE) figure gets a leg up if shareholder equity is minimized while profits remain stable.

The truth is that buybacks are increasingly being used to boost executive compensation. Shareholder dividends are paid out of a company’s net profit. The proverbial pie is divided into fewer pieces if there are fewer shareholders.

Many corporate bonus programs are predicated based on the business attaining certain financial goals. Common benchmarks include increased EPS and ROE ratios. Repurchasing outstanding shares enables businesses to increase executive compensation by making the company appear more profitable.

How Does Equity Financing Work?

Equity financing is the process of raising capital by selling shares of the company. Startup private companies can engage in equity financing by selling shares just as companies on a stock exchange can. The shares typically come with ownership and voting rights.

What Are Blue Chip Stocks?

Blue chip stocks are issued by industry-leading, publicly traded companies. They’re marked by large market capitalizations and they often pay dividends.

How Is Return on Equity Calculated?

A company’s net income is divided by shareholder equity to arrive at return on equity. ROE is expressed as a percentage and a higher number is better.

The Bottom Line

A company might elect to buy back outstanding shares for several reasons. Some may be strategic. The process involves repurchasing and effectively taking back shares that have previously been purchased by and issued to its stockholders.

This event can present an advantage to the remaining shareholders because their ownership stake will generally increase as the number of outstanding stock shares decreases. Shareholders who sell give up future dividends, if any, but they should receive current fair market value for the shares they sell back to the company.