Wondering Why Do Companies Buy Back Shares?
What is the reason why companies buy back their own shares?
What’s important to know?
In this article, I will break down the question of Why Do Companies Buy Back Shares so you know all there is to know about it!
Keep reading as we have gathered exactly the information that you need!
Let me explain to you why companies buy back their own shares!
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Let’s get started!
What Is A Stock Buyback
A stock buyback is when a company uses its cash to buy shares of its own stock.
In other words, the company uses its money to invest in itself.
When a company pays an investor the fair market value for the shares, it will reduce the total number of outstanding shares in the market and absorb that stock in its treasury.
The company can choose to buy the stocks in the open market or it can buy the shares back directly from its shareholders.
For the company to initiate a stock buyback, the company’s board of directors will need to approve the share repurchase of shares and determine how much cash to use for this activity.
Also, the company cannot buy back shares by targeting specific shareholders.
The buyback of shares must be available to anyone who is looking to sell their shares without the influence of any kind.
Keep reading as I will break down the main reasons why companies will choose to use their cash to buy their own stock instead of investing it in other ways.
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Why Do Companies Buy Back Shares
There are many reasons why companies buy back their own shares in an attempt to create more value for the shareholders.
Stock buyback seems strange as we all know that companies generally are eager to sell shares to raise capital.
So why would a company use its money to buy its own shares?
Well, although it sounds counter-intuitive to see companies use their capital to buy back their own shares, there are actually several advantages to doing so.
Keep reading as I will break down the most common reasons why companies will buy back shares.
Deploy Unused Cash
One reason why a company will buy back its own shares is to deploy unused cash on hand.
Carrying too much cash is not efficient as it does not create value for shareholders.
When a company has sufficient capital to pay for its business operations, it will need to decide what to do with the excess cash it has on hand.
One option is to buy back its own shares allowing it to reduce its cost of capital.
Paying dividends on stocks represents the cost of equity capital.
Reducing the total outstanding shares will directly result in a lower cost of equity capital as the company will need to disburse less dividends to its shareholders.
Maintain Stock Price
Another important reason why companies will buy back shares is to help maintain the stock price.
There are many investors that buy shares of companies offering dividends in a steady and consistent manner.
The more a company is able to pay dividends consistently, the more investors will want to acquire the shares of that company.
A company can choose to adopt a strategy of allocating some of its capital to buy back shares and some to pay dividends (rather than using all that money to pay dividends).
This way, should the economy slow down or markets dip, the company can buy back fewer shares and allocate that “saving” to maintaining its dividends.
Investors like companies that pay dividends and are able to keep paying dividends in good or bad economic conditions.
As a result, having a consistent share buy-back strategy can help a company weather different economic cycles and keep paying dividends.
Undervalued Stock Price
In situations when a company’s stock price is undervalued, buying back shares can be a great way to use excess capital and lower the company’s overall cost of capital.
In some situations, a company’s stock price falls as investors have panicked, are disappointed with the company’s latest financial performance, or for other reasons.
When the company considers that it is financially healthy and that investors are undervaluing its stocks, the company can buy back the shares at a low market price.
Then, when the share prices go back up, the company can reissue the shares at a higher price.
This way, the company is able to reduce its overall cost of equity capital without having to issue any new shares.
Boost Financial Ratios
A company can decide to buy back shares to appear more attractive to investors and achieve certain financial ratios.
When a company buys back its shares, it reduces the total number of shares outstanding.
As a result, its earnings per share ratio will get a boost.
Since many investors and market players look at metrics such as earnings per share and other ratios, a boost in earnings per share can lead to a short-term increase in the stock price.
With a higher stock price, the company’s price-to-earnings ratio will also get pushed upwards.
Another ratio that gets a boost is the return on equity ratio.
There can be an argument made about share buybacks providing companies with some tax efficiency.
When a company pays dividends to its shareholders, the shareholders are taxed on the dividend income.
However, when the company engages in share buyback leading to an increase in stock price, the value created for the shareholders does not result in a tax consequence until the shares are sold by the shareholders.
Share buyback also has an interesting psychological impact on investors and the market.
When a company buys back shares, it is using capital that it could have used to fund its business operations, engage in mergers and acquisitions, or invest more in research and development.
Investors perceive that the company is very confident about its business, growth potential, and has excess capital.
Inventors perceive this as a positive sign that the company is using excess capital to reinvest into itself.
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Why Companies Should Not Buy Back Shares
In some situations, companies should avoid buying back their own shares to avoid further problems down the road.
One reason why a company should not buy back its shares is that the company can use its cash to invest in projects that generate a higher return on investment.
In other words, buying back shares can lead to poor use of the company’s cash resources.
For instance, a company can acquire another company, launch a new product, invest in technology, or advance its research and development so it can create greater value for its shareholders.
Another reason why share buyback may not be a good option is that a company that is doing well and has excess cash will generally have higher stock prices.
Using excess cash to buy shares at high prices may not be the best way to put the cash to use.
In some situations, share buyback can increase the company’s overall risk profile.
Some companies may use low-interest debt to finance the buyback of their shares.
This strategy can backfire as the company will have to pay back its debt at some point in time in the future.
If the company is not careful, it can damage its liquidity position.
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So there you have it folks!
Why do companies buy back shares?
In a nutshell, companies buy back shares when they have excess cash and consider that reinvesting in their own company will bring greater value to their shareholders.
Fundamentally, companies operate to make profits and use their cash to create value.
A company can use its cash to make capital investments, acquire other businesses, pay dividends to shareholders, or buy back its own shares.
If the company believes that allocating some money to buy back its shares, after considering all other investment options, creates more value, then it would prefer that option.
Stock buybacks can help reduce a company’s overall cost of capital, raise stock prices, boost the company’s financial ratios, and let the company use cash that would not have been efficiently used otherwise.
Now that you know why companies buy back their own shares, good luck with your research!
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