When you hold shares of stock, you begin to hear a wide range of financial terms you may not have heard before. One of these terms is the “stock buyback” that can be a significant indicator of a company’s health. Stock buybacks are often done when sales have been flat year-over-year and revenues stagnant. A stock buyback is generally considered a sign of good corporate governance, but this is not always the case.
How stock buybacks are done
In a stock buyback shares are repurchased from the stock marketplace so that fewer shares are available for purchase. This action increases the relative value of the stocks held by the investors in the company. Stock buybacks may be “tendered” or public. Tendered buybacks make an offer to current stockholders to sell their stock at a favorable price. Public, or open-market, buybacks purchase the stock just as individual would, at market price.
Why do companies buy back stock?
Corporate news releases often claim that repurchasing their own stock is the best use for company cash, but this is not always the case. In many cases, the move improves the company’s prospect on the balance sheet, though not always in reality. The exact motivations behind the buyback can reveal whether is it truly a good financial move for the company or a diversionary tactic. Corporations often buy back stock when they believe their stock is undervalued.
Advantages of stock buybacks
Stock buybacks are usually a way for corporations to take care of their stockholders, increasing the value of their holdings and securing the financial integrity of the company. Purchasing outstanding shares increases the earnings per share, thus increasing the value of the shares that remain on the market. Shareholders’ stock who hold that stock find it has increased in value. This result can then spark more stock purchases. The supply of stock, however, has decreased, so the demand for the stock may increase dramatically.
Disadvantages of stock buybacks
Though often touted as a sign of good fiscal management, stock buybacks can also have a downside. One case in which a stock buyback is not good is when the corporation buys it in a period when the stock is overpriced. In this case, the stock will price will inevitably fall, reducing the asset value of the stock for the company, and also for the remaining stockholders. Another case when stock buybacks are not necessarily good is when it relates to employee stock option programs and executive compensation. These stock options can increase the number of stocks on the market, which dilutes the value of outstanding shares. The stock buyback helps to bring the share price back into line.
In order to know the motivation behind a corporation’s stock buyout, do a little research into the current earnings and outlook at financial data sites. This information can give you an idea into what’s behind the buyback, and whether you should rejoice, or become more cautious.