Why do companies buyback stock? There are a few reasons why companies may want to buyback their shares.
Let’s start by explaining the basics. A company’s goal is to grow. When companies want to grow the business, they raise capital (money) in a couple different ways, including:
- Obtaining a loan (i.e. from a bank or by issuing bonds).
- Issuing stock (equity).
Selling equity is the most expensive way to raise money to grow a business. This is because the company is selling a portion of all future earnings. On the flip side, this is exactly why you, as investor, want to purchase stocks. You want a piece of the pie. When a company buysback shares, the company’s ownership percentage increases. The business will not longer share their earnings with as many outside investors (consolidation).
Second, share buybacks can substitute a traditional dividend. When the company buysback shares, investors may receive an opportunity to receive a cash payment. Usually, the cash payment is an offer to sell shares above market price. When this occurs, the shares left in the market (shares outstanding), now have a higher value.
Third, buying back shares signals to investors that the company is confident in itself and willing to invest in itself. In turn, this signals financial stability and confidence in the future. On the flip side, stock buybacks can also be used to mask financial instability. For instance, the company can use a buyback to manipulate the EPS (earnings per share).
Some other reasons/side effects of stock buybacks, include:
- Providing large bonuses to company executives through stock options.
- Increasing debt (to fund the repurchase).
- Avoiding a hostile takeover.
Now that you know why companies buyback stock, you can do your research and study a company’s financial reports to determine the real reason behind their decision!