Stock buybacks refer to the repurchasing of shares of stock by the company that issued them. A buyback occurs when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously distributed among public and private investors. With stock buybacks, aka share buybacks, the company can purchase the stock on the open market or from its shareholders directly. In recent decades, share buybacks have overtaken dividends as a preferred way to return cash to shareholders. Though smaller companies may choose to exercise buybacks, blue-chip companies are much more likely to do so because of the cost involved.
Reasons for Buybacks
Since companies raise equity capital through the sale of common and preferred shares, it may seem counter-intuitive that a business might choose to give that money back. However, there are numerous reasons why it may be beneficial to a company to repurchase its shares, including ownership consolidation, undervaluation, and boosting its key financial ratios.
Unused Cash Is Costly
Each share of common stock represents a small stake in the ownership of the issuing company, including the right to vote on company policy and financial decisions. If a business has a managing owner and one million shareholders, it actually has 1,000,001 owners. Companies issue shares to raise equity capital to fund expansion, but if there are no potential growth opportunities in sight, holding on to all that unused equity funding means sharing ownership for no good reason.
Businesses that have expanded to dominate their industries, for example, may find that there is little more growth to be had. With so little headroom left to grow into, carrying large amounts of equity capital on the balance sheet becomes more of a burden than a blessing.
Shareholders demand returns on their investments in the form of dividends which is a cost of equity – so the business is essentially paying for the privilege of accessing funds it isn’t using. Buying back some or all of the outstanding shares can be a simple way to pay off investors and reduce the overall cost of capital. For this reason, Walt Disney (DIS) reduced its number of outstanding shares in the market by buying back 73.8 million shares, collectively valued at $7.5 billion, back in 2016.
It Preserves the Stock Price
Shareholders usually want a steady stream of increasing dividends from the company. And one of the goals of company executives is to maximize shareholder wealth. However, company executives must balance appeasing shareholders with staying nimble if the economy dips into a recession.
One of the hardest hit banks during the Great Recession was Bank of America Corporation (BAC). The bank has recovered nicely since then, but still has some work to do in getting back to its former glory. However, as of the end of 2017, Bank of America had bought back 509 million shares over the prior 12-month period and the bank plans to return over $17 billion to shareholders through share repurchases in 2018. Although the dividend has increased over the same period, the bank’s executive management has consistently allocated more cash to share repurchases rather than dividends.
Why are buybacks favored over dividends? If the economy slows or falls into recession, the bank might be forced to cut its dividend to preserve cash. The result would undoubtedly lead to a sell-off in the stock. However, if the bank decided to buy back fewer shares, achieving the same preservation of capital as a dividend cut, the stock price would likely take less of …