What Happens When a Company Buys Back Stock?

Save

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.

Related Searches

References

  • "PassTrak Series 7: General Securities Representative License Exam"; Dearborn Financial Services; 2003
Promoted By Zergnet

Comments

You May Also Like

Related Searches

Check It Out

4 Credit Myths That Are Absolutely False

M
Is DIY in your DNA? Become part of our maker community.
Submit Your Work!