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stock buyback

As you invest and build a portfolio, you’re likely to encounter common investing terms, such as “risk tolerance” or “diversification.” One term you may be less familiar with is “stock buyback”.

In a nutshell, a stock buyback occurs when a company buys back its own shares from the market. But why would a company do that? And what impact does it have on your portfolio if you own shares of that company’s stock? Here are the most important things to know about stock buybacks.

How Stock Buybacks Work

In terms of mechanics, a stock buyback involves a company that wants to purchase back its own shares and a purchasing agent who completes the transaction. David Russell, vice president at TradeStation, says companies typically hire an investment bank to buy a certain amount of stock back. The company’s board is responsible for authorizing a buyback and determining how much of the company’s capital to allocate to the purchase.

A company can ask shareholders to return a percentage of their shares voluntarily to the company. Investors decide how much of their shares, if any, they want to sell back and at what price, based on a range determined by the company.

The other way a stock buyback can be executed is open market trading. In this scenario, the company buys its own shares on the market, the same as any other investor would, paying market price for each share. It may sound complicated, but essentially, the company is investing in itself.

Why Do Companies Use Stock Buybacks?

stock buyback

It might seem counter-intuitive for a company to buy back shares of its own stock. After all, shouldn’t the company want those shares to be held by investors? But, there are several good reasons companies choose to pursue buybacks.

First, buying back shares can be a way to counter the potential undervaluing of the company’s stock. If a stock’s share price falls, then the company can send the market a positive signal by investing its capital in buying back shares. This can help restore confidence in the stock. That, in turn, could push share prices higher.

A stock buyback can also allow a company to reduce its cash outflows, without having to reduce the amount of the dividend paid to investors. When there are fewer shares that investors hold, the company needs to pay out fewer dividends. That allows companies to preserve capital after completing the buyback.

Buybacks reduce the amount of assets on a company’s balance sheet, which increases both return on equity and return on assets. Both are beneficial in terms of how the market views the financial stability of the company and its stock. A buyback can also result in a higher earnings per share ratio. That sends another positive signal to the market.

Russell says companies may also buy back stock to remove shares from the market that they paid to employees under stock-based compensation plans. Employees are given the option to sell back some of their shares, typically at a percentage of their total vested amount.

What Stock Buybacks Mean for Investors

Investor perceptions of a stock buyback vary. Factors include how it’s carried out and the impact on your portfolio. These factors aren’t always immediately clear.

“When a buyback is routine and expected, the market will typically price it in,” Russell says. “However, when a large increase is announced it can cause a rally – especially if a stock’s been under pressure. In that case, investors may think the company is ‘defending’ its price.”

A key upside of buybacks for investors is the reduction in the supply of shares. When there are fewer shares to go around, that can trigger a rise in prices. So after a buyback, you may own fewer shares but the shares you own are now more money. If you hold those investments in a taxable brokeage account, you won’t pay capital gains tax until you sell. If you hold your remaining shares longer than one year, you can take advantage of the long-term capital gains tax rate.

Additionally, when there are fewer shares to be traded on the open market, your overall ownership stake in the company increases. That means you could potentially benefit from a higher dividend payout going forward, since you’re entitled to a larger share of the company’s earnings.

Are There Downsides to Stock Buybacks?

stock buyback

A stock buyback could be a misfire for the company if the timing isn’t right. For instance, if a company announces a buyback when stock prices are high, that would require a higher outlay of capital.

Buybacks can also spell trouble for investors, depending on the motivation behind them. For example, if a company is buying back stock to try and inflate prices to attract more investors, it could be a sign that it’s desperate to raise capital.

As mentioned earlier, a buyback can trigger a higher earnings per share ratio. Normally, that’s a good thing and a sign of a healthy company. If the company is executing a buyback solely to improve the EPS, though, that doesn’t mean you’ll realize any tangible benefit in the long run. If anything, a sudden buyback announcement could mean that the company’s profits are declining. It could also mean its operational costs are too high. That puts the company on shaky ground financially.

So should you worry if a company you own stock in announces a buyback? Not necessarily. It’s helpful to understand why the company has decided to buy back some of its own stock and look at the bigger picture, in terms of the company’s fundamentals.

For instance, consider how much debt the company is carrying, what type of expansion plans it may have in the works and the stock’s dividend payout history. Look at the stock’s recent performance and compare that to its historical performance to see how share prices are trending. Look at what drove the previous buybacks, if the company has done this before. Also, consider what’s happening within the broader market.

“Stock buybacks are a routine part of the market that occasionally impact prices,” Russell says. “Investors should pay attention when a stock rallies from a low on a buyback announcement. That can sometimes indicate a turnaround is taking place.”

The Bottom Line

Stock buybacks occur when a publicly traded company decides to purchases large swaths of its own stock. There are a variety of reasons a company may do this. Reducing cash outflows and countering a potential undervaluing of shares are potential reasons. A stock buyback can mean many different things for investors. Make sure to examine the situation carefully and potentially. Also consider consulting with your financial advisor if a company you own stock in does a buyback.

Tips for Stock Investing

  • Working with a financial advisor can help you navigate events that can impact your portfolio, such as a stock buyback. Use SmartAsset’s financial advisor matching tool to get recommendations for up to three professionals in your local area. We fully vetted our advisors, and they are free of disclosures. You’ll have a chance to talk with each of your advisor matches before making a final choice.
  • If you’re planning to sell shares of stock after a buyback, take time to estimate your capital gains tax. A capital gains tax calculator can give you an idea of how much you may owe in taxes on your investment earnings.

Photo Credit: © iStock/simonkr, © iStock/ipopba, © iStock/Jirapong Manustrong

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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