The simplest definition of a share buyback is that it is when a company buys a portion of its own stock thereby reducing the number of shares available on the market. Generally speaking, there are three reasons a company might do this. One is to create my value for investors. The second is because they believe their stock is undervalued and they want it to go up. The third is to avoid hostile takeovers from other companies who are trying to gain controlling interest. However, what stock buybacks mean to investors isn’t quite so clearly defined.
The Benefits
When a company buys back some of its shares, they are taking them off the market and decreasing the number of shares available. So, if a company with 100,000 outstanding shares decides to buy back 25,000 of them, that means there are only 75,000 shares available. The investors who hold those shares will see that stock’s value per share rise over 25% practically overnight. Additionally, because the shares are worth more, the investors who hold stock in the company now have greater equity in the company as well.
Wait, There’s a Catch
While the aforementioned scenario sounds like every investor’s dream, a stock buyback could also be a clever ruse by a company to making their earnings per share look like they have increased when they really haven’t. Research done by Value Stock Guide says that investors need to keep in mind that the company’s financials haven’t changed; it just looks like they made more money per share because there are fewer shares available. A stock buyback can be one way to trick investors who are very concerned with earnings per share into thinking that the stock is worth more than it actually is.
The Downside
Another thing to keep in mind is that if a company institutes a share buyback program, it loses some of its intrinsic value. What this means is that the company has diverted its own financial capital away from projects that could promote growth such as product development or other ventures that could potentially have genuinely increased earnings. Even worse, if the company makes the mistake of buying its shares back at too high a price because they falsely believe it their stock is undervalued, then investors will lose more in the long run than they gain.
Just because a company announces that it is instituting a stock buyback program, that doesn’t always mean you should run out and buy as many shares as you can. Investors need to keep the big picture in mind and evaluate the company as a whole. For investors, stock buybacks can work either way. In some cases, they do make the shares more valuable, but they can also backfire and make the shares less valuable over time. As with any stock purchase, a buyback program is only one factor among many that investors need to consider.