Buyback (Stock) - Explained
What is a Stock Buyback?
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Table of ContentsWhat is a Stock Buyback?How Does a Stock Buyback Work? How Firms Buyback their SharesAcademic Research on Stock Buybacks
What is a Stock Buyback?
Buyback, commonly known as share repurchase, takes place when an organization tends to reduce its number of shares issued in the market by buying outstanding shares on its own. There can be a lot of reasons that firms buyback their shares including boosting the value of left over shares by decreasing their supply, or not allowing shareholders to have a controlling share in the company.
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How Does a Stock Buyback Work?
By using the buyback approach, a company invests in its own shares, or in itself. By making a reduction in the number of outstanding shares in the market, the company makes an increase in the portion of shares that investors or shareholders own. When a company's shares are undervalued in the market, it may follow the buyback strategy and offer returns to its investors.
Due to the bullish nature of the company, buyback results in increasing the amount of earnings for every share. And, it helps in increasing the stock price, provided price-to-earnings ratio is consistent. The share repurchase or buyback brings a decline in the quantum of shares issued in the market, thereby, increasing the value of each share in the company.
While the earning per share (EPS) and the price of stock rise, the price-to-earning ratio declines. Buyback is a way of giving assurance to investors that the company has created reserves for meeting contingent situations, and to fight economic issues, if any. Companies may follow buyback policy for compensating their employees and managerial team with financial incentives including stock options and stock rewards.
After buying back their own shares, companies issue them to their employees and management. This approach also enables to retain the position of current shareholders of the company. It is important to note that as companies utilize their retained earnings to buyback shares, the ultimate economic benefit offered to investors will be similar to the case when dividends were issued from the company's retained earnings.
How Firms Buyback their Shares
A company can use the buyback option in the following ways:
- Companies can tempt its existing shareholders with a tender offer in which they are given the option to tender (submit) at least a specific portion of their shares in a given period of time. In order to make the deal attractive, companies offer a premium amount that is more than the existing market price. The premium amount is offered so as to avoid shareholders from holding on to their shares in future, and submitting them now.
- Some companies prefer buying back their shares in the open market, and tend to design a specific share repurchase agreement that involves buying shares at specific periods of time or on constant basis.
A firm can fund buying back of shares with debt, that can be either through cash flow from the operational activities, or cash in hand. An expanded share buyback refers to the improvement in the current share repurchase program of a company which results in a steadier decline of its share float. The size of the expanded share buyback has a positive impact on the market, and vice-versa.
The expanded buyback, having a huge magnitude, tends to increase the share price. Buyback ratio is calculated by dividing the amount of buyback shelled out in the last year and the value of market capitalization at the time when buyback starts.
This helps to strike a contrast regarding the prospective effect of repurchases among various organizations. It also informs about how quickly the company will be able to offer returns to shareholders, and to what extent. As per the statistics, the organizations who keep buying back their shares on an ongoing basis have benefitted from market conditions.
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