Australia
Canada
United KingdomThadeus Geodfrey is an experienced and celebrated writer and self-taught trader specialising in cryptocurrencies and forex. Market analysis, identifying fraudulent brokers, and security are his cup of tea. At BrokerRaters Thadeus develops educational materials and user-guides, offer market insights, ensures our content conforms to the best standards. Join Thadeus to succeed in your trading endeavours.
Fact checked
Advertising Disclosure
We may receive compensation from our partners for placement of their products or services, which helps to maintain our site. We may also receive compensation if you click on certain links posted on our site. While compensation arrangements may affect the order, position or placement of product information, it doesn’t influence our assessment of those products.
Stock buybacks were legalised in many countries, including the US and the UK, a few decades ago. Since then, we’ve witnessed some breathtaking campaigns. Take Apple’s record-breaking buyback as an example. In May 2024, Apple announced its plan to repurchase $110 billion of stock, which sent shock waves through the financial and technology sectors.
No investor in the current age should dabble in stocks without a clear understanding of how buybacks work. Why? First and foremost, buybacks can significantly influence the involved company’s financial health and the value of each of the shares that remain in circulation. Our mission today is to help you understand how stock buybacks work and their impact on investors.
In This Guide
How Do Stock Buybacks Work?
Suppose you own company X’s shares. At some point, the company may decide to use its own cash to buy back the shares that you and other shareholders bought from it. Most companies do so when they want to reduce outstanding shares and increase the value of the remaining ones. Companies that believe their shares are undervalued often use this hack to turn the situation around.
Here’s a step-by-step breakdown of how stock buybacks work:
- Step 1: The company announces its plan to buy back shares and the money it plans to spend.
- Step 2: Willing shareholders sell their shares to the company, which uses money in its reserves or borrowed cash to fund the buyback.
- Step 3: The company reduces the volume of shares available in the market by retiring or cancelling the shares it buys.
- Step 4: The company’s profits become concentrated across a reduced number of shares, potentially increasing the value of each of the remaining shares.
Reasons Companies Buy Back Their Own Shares
Numerous financial and strategic reasons can force a company to repurchase sold shares. They include:
- To improve financial health
Suppose your company’s health doesn’t look too good. In that case, you can improve its image, especially to investors, through stock buybacks. If you repurchase some stocks, investors might take it as a sign of confidence in your company and an indicator of good financial health. Moreover, buybacks increase earnings per share (EPS), making your stocks more attractive to existing and new investors.
- To increase earnings per share
When a company buys back some shares, the number of outstanding shares dips. Consequently, the company’s earnings are divided among a smaller number of shares, leading to an increase in the revenue that goes to the remaining shareholders. Increased earnings per share make the company appear more profitable and draw in more investors.
- To consolidate ownership
Common shareholders can vote and influence company decisions. Decision-making can be slow and problematic when a company has too many common shareholders. To rectify this situation, the company may decide to reduce the number of people with voting power by buying back some shares.
- To address undervaluation
Considering the law of scarcity, a company’s stock is likely to be more valuable when demand is greater than availability. Otherwise, if supply is at an all-time high, the value of each share can dip significantly. With that in mind, companies that feel their shares are undervalued often buy back some shares from circulation, consequently inducing scarcity and driving up prices.
Impact of Stock Buybacks on Investors
Stock buybacks can have positive and negative impacts on investors. When a company repurchases some of its shares, the remaining shares attract increased earnings, directly benefiting the shareholders. Moreover, the shares that remain in circulation after a buyback are often pricier than before and in higher demand.
Unfortunately, stock buybacks come with their fair share of drawbacks. For starters, they encourage some companies to invest most of their cash in stock repurchases rather than in growth and expansion. Worse yet, companies can use buybacks to artificially inflate stock prices without improving their operations and fundamentals, which has a more long-lasting effect.
What Should Investors Look for When a Company Announces a Buyback?
If a company announces its buying back shares today, as one of the investors, you should assess the situation carefully to determine how it will affect your investments. Here’s what you should focus on:
Reason for the buyback: Research why the company wants to repurchase shares immediately after its officials announce the buyback. That will help you pinpoint issues like poor company health as soon as possible.
Buyback details: You should assess buyback details carefully for several reasons. First, a large buyback can indicate that the company is confident in its financial capacity and future standing, which is a good sign. Second, buyback details can help investors identify the true reason behind the company’s stock repurchase move.
The company’s financial health: As an investor, you should assess a company’s financial health as soon as it announces a buyback. That is because this move can reduce cash flow and affect the company’s ability to fund day-to-day operations or grow in the near future. Moreover, if the company uses borrowed money to repurchase shares, the additional debt can hurt leverage ratios like its equity-to-debt ratio.
Conclusion
Stock buybacks are common. However, Apple’s recent buyback has now made them a staple topic of discussion in investor circles. We’ve introduced you to the fundamentals of stock buybacks, including how they work and their impact on you as an investor. That shouldn’t be enough, though. If you’re an avid stock investor, you should research and learn more about buybacks to put yourself in the best position to make informed decisions and avoid potential financial setbacks.