In a stock buyback, a company buys back in the open market at the current prices its own stock that it previously sold to investors. A stock buyback is a popular method of enhancing shareholder value – i.e., increasing the stock price, or at least preventing it from sliding further.
Shares Outstanding and Per-share Numbers
A company may periodically sell more shares to investors in a secondary offering but by and large the number of shares issued and outstanding (in the hands of investors) remains stable. When a company reports quarterly results, it provides per-share numbers for easy comparison. For example, if XYZ reports net earnings of $100 million, it does not say much except that XYZ is profitable; but per-share earnings tell investors how profitable XYZ is relative to its size and peers. If XYZ has 100 million shares outstanding, its earnings per share (EPS) are $1. Investors can derive multiple per-share ratios from this number such as a price-to-earnings ratio (P/E), which is the current stock price divided by eps, for further comparisons and valuation. If XYZ stock is trading at $20, its current P/E is 20.
Effect of Share Buyback on Per-share Numbers
If XYZ decides to buy back 10 million shares, it will reduce the number of outstanding shares to 90 million; the net earnings will still be $100 million, so the EPS will increase to $1.11. With the stock currently at $20, the P/E will decrease to 18. Other investors enticed by a lower P/E may bid up XYZ stock to $22, which will return the P/E back to 20. A share buyback in this instance has pushed the stock price up 10 percent from $20 to $22.
Effect of Buyback on Stock Price
Stock prices often move as a result of the changing balance between supply and demand. Aggressive buying can push a stock price up. Buying 10 percent of outstanding stock is a lot of buying, and the increased demand for the company can push up the stock price.
Effect of Buyback on Share Availability
Stock prices are affected by the amount of stock in circulation. When too many investors chase a stock that is in short supply – i.e., with a small number of shares outstanding, they inevitably push up the stock price. By reducing the number of shares outstanding a buyback makes a stock scarcer and harder to buy, benefiting the stock price.
Psychological Effect of Stock Buyback on Investors
Companies must have cash to buy back their own stock. Cash can only come from profits. If investors see that of all the ways to use the profits a company chooses to buy back its own stock, it must mean that the stock represents a compelling value at the current price, is the best way to deploy corporate cash, so they start buying as well, further pushing up the stock price.