Objectives of Buyback of Shares

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A company will often buy back shares when it believes the stock price does not represent the real value of the company.
A company will often buy back shares when it believes the stock price does not represent the real value of the company. (Image: some cash image by Alexey Klementiev from Fotolia.com)

Investopedia defines a stock buyback plan, or stock repurchase plan, as a "program by which a company buys back its own shares from the marketplace, reducing the number of outstanding shares. This is usually an indication that the company's management thinks the shares are undervalued." As an investor, this should help you determine if the company is a good buy--for instance, if its share price is undervalued--or to sell the stock if the underlying objective is solely to make management look good by improving the company's financial ratios.

Stock Price Undervalued

A company's management team may decide to buy back shares for several reasons. One is the view that the shares are undervalued. An overall underperforming stock market or a company that has been hit with a scandal can signal to investors that the share price is worth more by purchasing its own stock. Investors often see this as a positive indicator to buy stock as well.

An extreme example of this was post-"Black Monday" in 1987 when the stock market dropped by more than 22 percent quickly. An article in the Journal of Corporation Law, among others, credits public companies buying up their own shares as one of the stabilizing factors and assisting in a 10 percent rebound in less than a week, as management teams felt that their stock was undervalued.

Improving Financial Ratios

A share buyback can positively influence several financial ratios management is measured by. In essence, the number of shares outstanding is reduced. The number of shares outstanding is a key element in several metrics and ratios, including earnings per share (EPS) and the price-to-earnings ratio (PE). Buying back shares also positively influences the return-on-asset ratio (ROA) and the return-on-equity ratio (ROE).

According to Investopedia, improvement of financial ratios is a poor reason for a company to use cash in a share buyback program. An investor could consider it a "sell" signal.

Dilution

Another reason that management may embark on a share buyback program is to prevent the risk of dilution. If, in the effort to attract and retain top talent, large share option grants were made available to employees and these share options are exercised and converted into shares, the overall number of issued shares in circulation could increase and hurt the company's financial metrics. To resolve this, management may offer to buy back the equivalent amount of shares on the open market to prevent the overall number of issued shares from increasing.

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