Trading Stock Repurchases and Buybacks
What is a Stock Repurchase or Buyback?
A stock buyback, or stock repurchase, is when a company buys some of its outstanding shares from the open market. When a company buys back its own shares of stock, it reduces the number of outstanding shares in the market. A stock repurchase also increases the overall ownership stake of each individual shareholder. Therefore, a stock buyback usually results in an increase to the market value of each share of the company’s stock.
Why Do Companies Buy Back Shares?
When a company finds that it has extra cash on hand, it can use that cash in a variety of ways. The company may decide to invest in research and development or property and equipment. The company may use the cash to pay down its outstanding debt. Alternatively, the company can use the cash to benefit shareholders directly in two different ways. Both dividend payouts and stock repurchases can benefit shareholders but in different ways.
Dividend Payouts v. Stock Repurchase
When a company issues a dividend, it pays out a certain dollar amount per share to each stockholder. The company is returning some of the value it created to its owners. Once a company begins issuing dividends to its shareholders, there is an implicit understanding in the market that the firm will continue to issue dividends on a quarterly or annual basis. Furthermore, shareholders will come to expect that the amount of the dividend will only increase each period. As a result, only mature companies tend to pay dividends to shareholders. A company that must use its available cash to pay out a dividend each period is not able to use that cash for other investments with growth potential for the firm. So, companies that are still in a growth phase may not want to commit to paying a regular dividend.
On the other hand, a stock repurchase allows a company to reward the shareholders with extra earnings without committing to the payment of dividends over the long-term. In general, companies should only initiate a stock buyback when the managers believe the shares are currently undervalued in the market. By purchasing the shares at a time when the market undervalues the company compared to the valuation by the company’s management, managers create additional return for the shareholders. Managers of the firm can also benefit from a stock repurchase. Since they often receive stock options as part of their compensation packages, managers only benefit from dividend payments if they already exercised those stock options. Those holding stock options, however, can also benefit from the higher stock price over both the short and long-term. So, managers may be more inclined to initiate a stock repurchase compared to a dividend payment.
Why Stock Prices Rise After Buybacks
Here’s the math behind the phenomenon. Let’s say a company is valued at $100 million based on expected future cash flows and subtracting out the company’s debt and liabilities. So the total value of the firm equity is $100 million and gets spread among the current shareholders. If there are a total of 1 million shares outstanding, the value of each share is $100. Now assume that the company decides to repurchase 100,000 shares. That means there are now 990,000 shares outstanding, but the value of the firm and shareholder equity does not change. Since the $100 million equity valuation gets spread across fewer outstanding shares, the price of each share increases. In this example, each share would now be worth $101.01.
Over the past few years, some companies have been repurchasing an enormous amount of shares. Apple started has repurchased 66.3 million shares since 2013. As a result of this massive buyback, Apple shareholders receive 21% higher earnings per share on their investment than they would if the company had not executed its stock buyback program.
ExxonMobil spent $203 billion repurchasing shares from 2003-2013. Oil companies report metrics such as production per share, and the repurchases allowed ExxonMobil to improve its production per share by 48%. Shareholders also received dividend income during this time and experienced a 267% total return during that decade.
In order to execute a stock repurchase, the company’s managers must get approval from the Board of Directors. The company issues a press release with the details of the amount of shares it has been authorized to purchase, so investors know about the buyback before it happens.
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