Repurchasing shares will typically raise earnings per share and the market tends to respond favorably when buyback announcements are made.
Some critics assert that companies should instead utilize their cash for other uses rather than buyback shares, since an improperly executed buyback may destroy value by starving research and development initiatives or infrastructure upgrades of capital resources they could invest.
Why Companies Buy Back Shares
Companies have several ways of returning cash to shareholders: buyback, dividend, or investing in new projects. While buyback may be preferred if the stock appears undervalued, dividends or investing may also work.
Repurchasing shares should in theory help strengthen a stock price because reducing outstanding shares increases each one’s worth and therefore makes each share worth a greater portion of the company.
Critics fear that buybacks could artificially inflate stock prices or that managers could take advantage of buyback announcements to enrich themselves through stock price gains. Studies (Vermaelen and Comment, among others) have reported this effect as evidence.
Repurchases conducted through open market transactions treat all investors equally, and unlike cutting dividends, shareholders tend not to react strongly when management decides whether or not repurchasing decisions should take place based on firm needs and management’s discretion. It’s essential that management has an established track record in making wise investments with shareholder funds.
How They Do It
Companies typically purchase shares back through open market transactions rather than from specific shareholders to ensure equity for all investors. When an announcement of share buyback occurs, markets often interpret it as a positive signal from management who believe their stocks have been undervalued by the market.
Reducing outstanding shares also increases earnings per share (EPS), even if net income declines, making the company appear more valuable on a price-earnings ratio basis; especially during bull markets when stock options may be included as employee compensation packages.
Grullon and Michaely (2000) report that, on average, firms that repurchase shares experience faster earnings growth. It should be noted, however, that announcements of share buybacks do not necessarily lead to immediate increases in share prices; sometimes this reaction takes months; managers must recognize when the company is undervalued so as to be successful with such programs.
The Returns
Share buybacks increase a company’s shares by decreasing the total number of outstanding stocks and increasing earnings per share (EPS), one of the most widely-used metrics used to evaluate companies.
Buybacks also help improve other financial metrics, including return on assets and equity returns, while mitigating employee stock options’ potential for dilution.
Investors sometimes favor companies that announce share buybacks because this indicates management’s belief that the market has overvalued them. Managers who can identify undervalued shares tend to be rewarded, often leading to share price spikes following announcements of buybacks. Unfortunately, however, buybacks don’t guarantee price increases or translate directly to higher future cash flows – the repurchased shares either retire or counted as Treasury shares which do not benefit from future dividend payments.
Taxes
United States-based corporations generally reward shareholders with cash dividends as an appreciation of their capital contributions. Listed companies may also buy back shares on the open market or through tender offers sent directly to shareholders offering them the option of selling at a fixed price; such purchases reduce outstanding shares, thus raising stock prices over time.
Studies on the signals buybacks send to the market have suggested that earnings per share rise following announcements of buybacks, with higher growth rates immediately thereafter. Other research suggests firm risk decreases after announcements, although that finding is contrary to traditional signaling theories.
Opponents of buybacks allege they represent a form of speculative corporate behavior, encouraging executives to pursue short-term financial gains rather than investing in productive assets in the form of long-term dividends for workers and noninvestor shareholders. They further contend that buying back shares diverts funds away from those who would otherwise receive higher dividends – thus diminishing worker wage benefits and dividend payments for noninvestor shareholders.
