Companies that want to reduce their number of outstanding shares or distribute accumulated money to shareholders indirectly can use a stock buyback to accomplish either objective. A stock buyback allows a company to essentially invest in itself by removing some of the outstanding stock shares from the market place. This can help reduce share dilution and can make it easier to make earnings per share goals in future quarters. In addition, a stock buyback is often seen as an indicator that the management of the company has confidence that the current share prices do not represent the true value of the company and that the shares are underpriced in the market.
Companies can accomplish a buyback in a number of ways. The first, and most common, is referred to as an open market repurchase. As the name implies, this type of repurchase uses the market structures to slowly accumulate company shares with the intent of removing those shares from circulation. The company will face limits, not only from its own internal procedures but from market regulations enforced by the Security and Exchange Commission. For example, the company cannot use more than one broker to buy the stock in a given day, cannot make its market offer the opening offer of the day, and cannot set a buyback price that is higher than the current or most recent asking price. The regulations are complex, but the short result is that the company cannot buyback its shares in a way that directly impacts the price, because that would be a violation of market manipulation regulations.
Companies interested in a buyback but interested in using the open market can perform a tender offer, in which the company offers to buy a certain number of shares at a particular price. These can be offered to shareholders and held open for a particular time at a fixed price, or can be performed through the use of a Dutch Auction. In either case, the tender offer regulations by the SEC govern the way that the company can proceed.
Leavings aside direct influence on price, which the tender offer and open market regulations are supposed to prevent, the announcement of a stock buyback program almost always affects the price of a stock share indirectly, because it provides very strong evidence that the company has strong faith that its future earnings will remain high. This is for three reasons: first, a company will not normally expend its cash in a repurchase if there is any chance that it will have to reduce dividends in the near future. So the buyback is a strong signal that the company will continue paying dividends without reduction in the near future. Second, the company will not normally overpay for any asset (in fact, the managers have a fiduciary duty to not overpay) and therefore a repurchase is an indication that the people who know the company best are confident that the price is currently a bargain. Third, a stock repurchase has the effect of making all the remaining stock more valuable because future earnings will be divided among fewer shares.
As a result, announcements of stock buybacks often trigger strong buying and the market forces will result in a short-term increase in share prices. Over the long term, the price will also likely increase because the earnings per share and dividend yield will likely increase with the new less-diluted number of shares. In the medium term, between the initial buying pressure from the announcement and before the reduction of dilution takes effect, the buyback’s affect on share prices will be less significant.