Share Buybacks: How They Work and What They Mean for Investors
A share buyback is when a company repurchases its own shares from the market, reducing the number in circulation. Also known as a share repurchase or stock buyback, it's one of two main ways companies return money to shareholders, the other being dividends.
In this article, we look at how share buybacks work, why companies do them, what effect they have on share price and how they compare to dividends.
The information in this article is provided for educational purposes only and does not constitute financial advice. Consult a financial advisor before making investment decisions.
Table of Contents
What Is a Share Buyback?
A share buyback is when a company purchases shares of its own stock, reducing the number of shares in circulation. This process is also referred to as a stock buyback or a share repurchase.
Once a company buys the stock, it’s no longer counted amongst its outstanding shares, which is the total number held by all shareholders. With fewer outstanding shares, each remaining one represents a slightly larger stake in the company.
Together with dividends, buybacks are one of the two primary methods companies have of returning cash to shareholders; however, the two work in very different ways. A dividend represents a direct payment to shareholders, whereas a buyback works by adjusting the ownership structure of the company.
How Do Share Buybacks Work?
Before a company can begin a buyback, it typically needs either board or shareholder approval, depending on where it is incorporated.
Once approved, the company announces a buyback programme, usually setting a maximum amount to repurchase rather than committing to a fixed number. This means that companies may end up buying back less than the full amount authorised.
Open Market vs Tender Offer
When it comes to repurchasing the shares, the company can either do so on the open market or via a tender offer.
Most commonly, companies opt to buy shares on the open market over time, in which case, there is no fixed price and the company acts as any other buyer, purchasing shares through a broker. Buying on the open market gives the company the flexibility to speed up or slow down the rate of its purchases depending on market conditions.
However, some companies may choose to go directly to their shareholders and offer them a fixed price for their shares within a set window. This is known as a tender offer, and the price is usually set at a premium to the market value to compensate shareholders for selling rather than holding onto their position.
What Happens to Repurchased Shares?
Once a company buys back its own shares, it typically deals with them in one of two ways:
- Treasury Shares: The company holds the repurchased shares rather than cancelling them immediately. This is a common first step, as it gives the company the flexibility to reissue the shares later or cancel them further down the line.
- Cancellation: The shares are permanently retired and removed from the share register. This can happen immediately on repurchase or, as is often the case, after a period held in treasury.
Why Do Companies Buy Back Shares?
Companies choose share buybacks for a range of reasons, sometimes more than one at a time:
- Returning cash to shareholders without committing to an ongoing payment
- Signalling confidence that management sees the shares as good value
- Offsetting dilution from employee share schemes and options
- Boosting earnings per share (EPS), a metric widely used to assess profitability
- Reducing shares in circulation, which can support the share price
- Deterring a hostile takeover by reducing the stock available to an acquirer
The EPS effect is mechanical rather than a sign of underlying improvement; with fewer shares outstanding, the same earnings are divided among a smaller number of shares, so EPS rises even if the company's underlying performance hasn't changed.
Buybacks also offset the dilution that comes from employee share schemes. Companies that grant shares or options as part of employee pay steadily increase the number of shares outstanding, which dilutes existing shareholders. A buyback removes shares elsewhere to help keep the overall count roughly stable.
How a Share Buyback Affects Share Price
During a stock buyback, a company spends cash and gets shares in return. This means that cash is leaving the business, but this is matched by a reduction in the number of outstanding shares.
These mechanics mean that a share buyback doesn't automatically affect the share price; more important is what else is going on and how the market reacts.
Signalling Confidence
A buyback can be interpreted as a sign of confidence, that management thinks the company's shares are undervalued. This may improve investor sentiment around the stock and contribute to a higher share price.
However, it won’t always be received in this manner. Investors may instead question why a business is using its cash to repurchase shares rather than investing in future growth.
Boosting Earnings per Share
If a company’s earnings stay the same, reducing the share count by repurchasing stock can boost earnings per share (EPS).
Because EPS is a metric which many investors use when analysing a company, this increase may make shares look more attractively valued than they did before, even if the underlying performance hasn’t actually changed.
For example, a company which has earnings of $1 million and 1 million shares outstanding, has an EPS of $1. If it repurchases 100,000 shares whilst earnings remain unchanged, EPS becomes about $1.11 ($1 million / 900,000). In this example, earnings haven’t changed, but because there are fewer shares, EPS has risen.
Supply and Demand
If a company enters the market as a buyer whilst simultaneously removing shares from circulation, it’s increasing demand whilst reducing supply. All things being equal, this can have an upward impact on share price during the course of the buyback.
However, the effect of this may be limited if the share buyback is small relative to normal trading volumes or, as is often the case, the buyback is spread over a prolonged period.
Share Buyback Benefits and Disadvantages
Share buybacks have both advantages and disadvantages for shareholders.
Advantages
- Higher Ownership Per Share: Once shares are repurchased, each remaining share represents a larger slice of the overall company.
- Tax Efficiency: Buybacks themselves don't typically trigger a tax event for shareholders who don't sell. This is different to a dividend, the receipt of which is typically taxable, although exact treatment depends on jurisdiction and individual circumstances.
- Improved Per-Share Metrics: Fewer shares outstanding can boost earnings per share, which may make the stock appear more attractively valued to prospective investors.
- Confidence Signal: A buyback is often read by the market as a sign that management believes shares are undervalued.
- Flexibility for the Company: A share buyback can be paused or scaled back without attracting the negativity associated with cutting or suspending a dividend.
Disadvantages
- Value Destruction if the Company Overpays: Repurchasing shares above their fair value wastes company cash and works against shareholders who remain invested.
- Opportunity Cost: Cash spent on a buyback isn't available for other uses, such as investing in future growth or paying down debt.
- Added Risk if Debt-Funded: Some companies fund buybacks with borrowing, which can add financial risk as well as borrowing costs.
- Can Mask Weaker Growth: A rising EPS driven exclusively by a shrinking share count may be used to hide the fact that the business isn't actually growing.
- Misaligned Incentives: Executives whose pay is tied to EPS or share price targets may be inclined to favour buybacks over other, better uses of capital.
- Cyclicality: Companies often buy back the most when the company is in good health and cash is abundant, during which time share price may be more expensive. They then dial back programmes during downturns, when shares may be cheaper.
Share Buyback vs Dividend
Share buybacks and dividends are two ways a company can return cash to shareholders.
With a dividend, eligible shareholders tend to receive a cash payment for each share they hold. With a share buyback, the company repurchases shares, reducing the number of shares outstanding.
Which is "better" for an investor typically comes down to what they want from their holding.
Someone looking for a regular income stream, to spend or reinvest as they see fit, is likely to prefer a dividend. However, someone who doesn't need income right now, and would otherwise reinvest a dividend anyway, may find a buyback achieves a similar outcome whilst avoiding a taxable event and any fees incurred from reinvesting.
How to Assess a Company's Buyback Programme
When a company repurchases shares, its share count goes down, meaning that remaining shareholders will see their stake in the business increase.
However, whether or not that provides real value to shareholders depends largely on the price at which the shares are repurchased.
If a company buys back shares whilst they are attractively priced, it can provide value to shareholders; however, if they overpay, it can destroy value for ongoing shareholders whilst benefitting those that sold.
To understand why that is, forget about share buybacks for a moment and consider any purchase. If you pay $100 for an asset which is only worth $75, you’ve essentially just wasted $25.
That $25 is gone forever, when you could have used it to buy something else. Meanwhile, the person selling has benefitted at your expense and walked off with an extra $25 in their pocket.
You can apply the exact same logic to share repurchases. If a company overpays for its own shares, it’s wasting cash and destroying value for ongoing shareholders by transferring the company’s wealth to the departing shareholders.
Besides the price/value relationship, other questions worth asking when assessing a share buyback include:
- Is it funded from surplus cash or operating cash flow, or by debt? The former is generally more sustainable, whilst the latter adds financial risk as well as borrowing costs.
- Is the share count actually falling? Comparing shares outstanding across a few years of annual reports shows whether repurchases are outpacing dilution from employee share schemes.
- Does the company still have sufficient cash? Once the buyback has been taken into account, does the company still have enough cash for its operations and planned investments?
Frequently Asked Questions
Do I have to sell my shares when a company announces a buyback?
No. An open market buyback doesn’t require anything from existing shareholders; the company simply purchases shares on the open market from normal sellers. Anyone who holds on keeps their shares as before, with a slightly larger ownership stake as the share count falls. A tender offer does invite shareholders to sell at a set price, but participation is completely optional.
Can a company pause or cancel a buyback programme partway through?
Yes. A share buyback is typically announced as authorisation to repurchase shares up to a maximum amount. The number is usually not a binding commitment, and companies may pause or even stop the buyback before reaching that limit if circumstances change.
Do share buybacks always increase the share price?
No. A buyback conducted at a fair price is theoretically neutral to the value of an existing holding, and one conducted at an inflated price can destroy value for ongoing shareholders. Share price movements around a buyback are typically driven by the market reaction as well as the effect on supply and demand.
Are share buybacks taxed?
Typically, not for shareholders who don’t sell, since no income is received and there is no gain to tax. Naturally, a shareholder who does sell shares back to the company may be liable to tax on any gain, depending on jurisdiction and individual circumstances. The company conducting the buyback may also be liable to tax. Exact treatment varies by jurisdiction, so it’s always worth checking local rules rather than assuming.
Are share buybacks better than dividends for shareholders?
Neither is inherently preferable; it largely depends on what the shareholder is looking for. An investor seeking a predictable income stream is likely to prefer a dividend, whilst one who doesn’t need cash now and would otherwise just reinvest a cash dividend may find a buyback achieves a similar outcome with less hassle and expense.
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