What Is the Stock Buyback Theory?
When a company goes public, it issues shares of stock in exchange for an investment in the company. After this original offering, called an IPO, the company has little control over its actual stock price, as the price is set by buyers and sellers in the stock market. A company can choose to buy its own stock. Doing so is called a stock buyback. Such buybacks can be beneficial to a company and its stock.
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Function
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When a company purchases its own stock, it removes those shares from the marketplace. Since there are a finite number of company shares available, this has the affect of reducing the number of shares that can be bought and sold on the open market.
Benefits
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The stock buyback theory is that by removing shares from the marketplace, the supply of stock is reduced. Thus, according to the law of supply and demand, the stock price should rise, all other things being equal. Additionally, the company accumulates shares of stock which can be used to redeem stock options.
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Warning
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Just because a company buys back its stock, does not mean its stock price will rise immediately, if at all. Although there are a limited number of stock shares for a company, the number for most publicly traded companies is in the several millions of shares. Thus, buybacks may not make a significant change in the overall number of shares in the marketplace.
Considerations
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The most important consideration in a stock buyback is the reason for the buyback. A company that believes its stock is significantly undervalued might purchase shares because it believes them to be a good investment. A company with lots of cash and nothing to do with it might buy back its stock just to use some of its cash (although it should pay a dividend instead). Additionally, a company may purchase its own stock as a desperate attempt to make the stock price rise against the fundamentals of the company. This, of course, could be a bad sign.
Time Frame
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Stock buybacks are authorized in a manner determined by company by-laws and announced according to securities trading rules and regulations. Stock buybacks are generally limited to how long the shares may be purchased. However, this limit is most often a few years.
Misconceptions
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A company cannot buy its stock on a whim in the open marketplace. As the ultimate "insider", the company may only purchase its stock after making the appropriate filings and disclosures.
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