When a company performs a share buyback, it can do several things with those newly repurchased securities.
First, it can reissue the stock on the stock market at a later time. In the case of a stock reissue, the stock is not canceled but is sold again under the same stock number as it had previously. Or, it may give or sell the stock to its employees as some type of employee compensation or stock sale.
Finally, the company can retire the securities. In order to retire stock, the company must first buy back the shares and then cancel them. Shares cannot be reissued on the market, and are considered to have no financial value. They are null and void of ownership in the company.
Key Takeaways
- A share buyback is a decision by a company to repurchase some of its own shares in the open market.
- A company might buy back its shares to boost the value of the stock and to improve its financial statements.
- These shares may be allocated for employee compensation, held for a later secondary offering, or retired.
- Companies tend to repurchase shares when they have cash on hand, and the stock market is on an upswing. There is a risk that the stock price could fall after a buyback.
How Buybacks Work
In a buyback, a company buys its own shares directly from the market or offers its shareholders the option of tendering their shares directly to the company at a fixed price. A share buyback reduces the number of outstanding shares, which increases both the demand for the shares and the price.
The stock’s earnings per share thus increases while the price-to-earnings ratio (P/E) decreases. A share repurchase can demonstrate to investors that the business has sufficient cash set aside for emergencies and a low probability of economic troubles.
Stock is repurchased from the money saved in the company’s retained earnings, or else a company can fund its buyback by taking on debt through bond issuance. After the stock is repurchased, the issuer or transfer agent acting on behalf of the share issuer must follow a number of Securities and Exchange Commission rules.
The stated goals of the SEC’s rules are to reduce and eliminate fraud resulting from the use of canceled securities, reduce the need for physical movement of securities, and improve the processing and transferring, as well as those processes involved in securities transactions. There have been occasions in which canceled securities have gone missing and appeared on the international market as current and valid.
Companies will also have to start paying taxes on any buybacks. The Inflation Reduction Act was passed in August 2022, which stipulates that public domestic companies must pay a 1% excise tax on stock buybacks starting after Dec. 31, 2022.
Employee Stock Compensation
One thing that a company can do with its bought-back shares is allocate them to employees as stock compensation. A company that offers stock compensation can give employees stock options that offer the right to purchase shares of the company’s stock at a predetermined price, also referred to as exercise price.
$881.7 billion
Total 2021 buybacks of S&P 500 companies.
This right may vest with time, allowing employees to gain control of this option after working for the company for a certain period of time. When the option vests, they gain the right to sell or transfer the option. This method encourages employees to stick with the company for the long term. However, the option typically has an expiration.
The stock held in reserve for these options or for direct stock compensation can come directly from a buyback.
Secondary Offers
If a company believes that its shares are currently priced too low, it can buy back its shares now with the intention of re-offering them to the public at a later date when the share price has recovered, or after the company has exhibited promising growth prospects.
Also known as a follow-on offering or subsequent offering, the secondary offering will occur when a company again places these shares on the market, thus re-diluting existing shares. This type of secondary offering happens when a company’s board of directors agrees to increase the share float for the purpose of selling more equity.
When the number of outstanding shares increases, this causes a dilution of per-share earnings. The resulting influx of cash is helpful in achieving the longer-term goals of a company or it can be used to pay off debt or finance expansion. Some shareholders’ shorter-term horizons may not view the event as a positive.
Retired Shares
Shares that have been bought back can be retired, or nullified—unable to be re-issued or transferred. Securities that have been retired, or canceled, must be clearly marked with the word “canceled.” Canceled securities must be kept in a dedicated, secure storage area. Transfer agents must keep a retrievable database of all canceled or destroyed stock.
Finally, transfer agents must write and follow a set of procedures on how to deal with canceled or otherwise terminated stock. It is worth noting that the SEC does not mean to interfere with scripophily, but has to institute regulations in order to prevent fraud and theft.
What Happens to the Share Price After a Buyback?
After a stock buyback, the share price of a company increases. This is so because the supply of shares has been reduced, which increases the price. This can be matched with static or increased demand for the shares, which also has an upward pressure on price. The increase is usually temporary and considered to be artificial as opposed to an accurate valuation of the company.
Do I Have To Sell My Shares in a Buyback?
As a shareholder you are not required to sell your shares back to the company in a share buyback; the company cannot make you do so; however, companies do offer a premium over the market price of the share to entice investors to sell.
How Do Companies Pay for a Buyback?
Companies can pay for a stock buyback through cash on hand or through debt financing (borrowing money). Companies will either buy their shares on the market or purchase shares from existing shareholders.
The Bottom Line
Companies buy back their shares for a variety of reasons, which include boosting the share price, the earnings per share, consolidation of ownership, reducing the cost of capital, and providing an increase in value to investors.
Once a company has completed its share buyback, it can retire those shares, hold them for release back into the market at a future date, or provide them to employees as a form of compensation. A buyback comes with both pros and cons, and as an investor it’s important to understand why a company is buying back its share and how that affects its value for the long-term, allowing you as an investor to make prudent investment choices.