How stock buybacks work
A share repurchase can reduce a company’s share count and lift EPS, but that arithmetic does not show that total profits have grown.
By Jordan Bell · Startups & Deals Reporter
· 4 min read
A stock buyback, also called a share repurchase, is when a company buys its own outstanding shares from investors. Fewer shares outstanding mean each remaining share represents a larger ownership stake, and earnings per share can rise even when the company’s total earnings do not.
For investors, the key is to separate that mechanical per-share effect from a change in the underlying business. A buyback does not guarantee that a stock’s price will rise.
How a buyback happens
A company’s board typically authorizes a repurchase program with a maximum dollar amount or share count. That authorization permits purchases, but it does not require the company to use the full amount.
The most prevalent method is an open-market repurchase, in which the company buys shares in the market over time. The CFA Institute Research Foundation says companies retain substantial discretion over whether, when and how much to purchase under these programs.
A company can also make a tender offer, inviting shareholders to sell some or all of their shares during a specified period, often at a premium to the current market price. Shareholders can choose whether to participate.
Companies can fund repurchases with cash on hand, operating cash flow or debt, according to Investopedia. The shares bought back may be retired or held as treasury stock. In either case, they do not have voting or cash-flow rights while they are out of public holders’ hands; treasury shares can later be reissued.
For U.S.-listed companies, SEC Rule 10b-18 provides a conditional safe harbor from market-manipulation liability for open-market repurchases. The conditions cover the manner, timing, price and volume of purchases. The rule does not require a company to conduct a buyback.
Why fewer shares can raise EPS
Earnings per share, or EPS, equals total earnings divided by shares outstanding. When the denominator falls, EPS rises if total earnings stay the same.
Consider a hypothetical company that earns $100 million and has 100 million shares outstanding. Its EPS is $1. If it repurchases and retires 10 million shares while earnings remain $100 million, EPS becomes about $1.11 across 90 million shares.
The ownership math changes too. If a company had 100 shares outstanding, one share represented 1% of the company. After 10 shares are retired, that same share represents about 1.11%.
A higher EPS after a buyback can therefore come from fewer shares, higher total earnings, or both. It does not, by itself, demonstrate that the company has become more profitable.
Why companies use buybacks
- To return cash to shareholders.
- To offset dilution, the reduction in existing shareholders’ percentage ownership when new shares are issued, including through employee stock compensation.
- Because management believes the shares are undervalued.
- To reduce the share count and increase per-share measures such as EPS.
Buybacks can give companies flexibility in the timing and amount of a payout, according to the Tax Foundation. A dividend, by contrast, distributes cash to eligible shareholders, while a buyback pays investors who sell shares into the program or tender offer.
What to watch in a buyback announcement
- Check whether the company announced an authorization or reported completed purchases. An authorization may be partly used or unused.
- Compare shares repurchased with shares issued for employee compensation. A program can offset dilution without materially reducing the total share count.
- Identify the funding source. Investopedia notes that buybacks can use cash, operating cash flow or debt, while depleted cash reserves can create added risk in an economic downturn.
- Compare total earnings growth with EPS growth. EPS can increase because the share count declined.
Buyback yield is another way to size up a program. It measures repurchase spending relative to market capitalization, which is the market value of a company’s outstanding equity. Schwab’s example: $5 billion in repurchases by a company with a $100 billion market capitalization equals a 5% buyback yield. The measure shows spending relative to company size, not whether the repurchases created value.
Do buybacks reduce investment?
The answer is unsettled. Critics argue that buybacks can leave less cash for investment or weaken a company’s financial cushion. But a Federal Reserve research note said the causal connection between payouts and capital investment is unclear. Its cross-country analysis found no statistically significant relationship between changes in combined buybacks and dividends and investment.
Frequently asked questions
What does a share-repurchase authorization mean?
It means the board has authorized the company to repurchase up to a stated amount of stock. In an open-market program, the company has discretion over implementation and is not obliged to use the full authorization.
What happens to shares a company buys back?
They may be retired or held as treasury stock. The CFA Institute Research Foundation says repurchased shares do not have voting or cash-flow rights when retired or while held as treasury stock; treasury shares can be reissued later.
Sources
- How Stock Buybacks Work and Why They Matter — www.schwab.com
- Understanding Stock Buybacks: Benefits, Drawbacks, and Strategic ... — www.investopedia.com
- stock buyback motivations and consequences - a literature review — www.cfainstitute.org
- The Fed - Corporate Buybacks and Capital Investment: An International ... — www.federalreserve.gov
- The Economics of Stock Buybacks — taxfoundation.org
