A share buyback occurs when a company purchases its own shares. It often represents a significant event for the company and can have a big impact on the fortunes of shareholders. In most cases, even the mere announcement of an upcoming buyback is enough to move the price of a stock. If you are an active investor, it's important to understand the basics of a buyback.
The goal of a share buyback is to reduce the number of outstanding shares and thereby increase the earnings per share. In other words, a share buyback attempts to increase the size of each slice cut from a pie by reducing the number of slices. Assume a firm that earns $10 million per year and distributes half of this sum as dividends to 2.5 million shares. Earnings per (EPS) share would be $4, while dividend per share equals $2. If the firm can buy half a million of its shares and reduce the number of outstanding shares to 2 million, the EPS would climb to $5, while the dividend per share would advance to $2.50 -- all with no actual increase in profitability.
Open Market Purchases
A company can buy its shares either through open market purchases or a tender offer. When using the former method, the company buys its stock just like any other investor. By working with a broker, the firm will slowly accumulate its stock at prevailing prices. Depending on the number of shares the company intends to buy back, and the price it is willing to pay, this process can take many months to complete. Shares bought back through this method, or a tender offer, are retired and will not receive dividends. Therefore, a share buyback reduces the outstanding stock and boosts profitability per unit share.
In a tender offer, the firm makes a public announcement that it is willing to pay a specific amount of cash for each of its outstanding shares, between specific dates. For example, a company might announce that between Jan. 1 and Feb. 15 it will pay $10 for each of its shares until it accumulates 2 million shares. The price in such a tender offer has to exceed the prevailing market price at the time of the announcement, or stockholders will make more money by selling the shares to other investors instead of the firm. If the desired number of shares are accumulated before the deadline, the firm reserves the right to halt the purchases early.
Pros and Cons
While a buyback will increase the net earnings and dividends per share, it will cost the firm a great deal of cash. The question always is whether it is in the stockholders' best interest to pursue new investment opportunities with this cash and thereby boost earnings, instead of using the cash to buy back corporate stock. The answer depends on a variety of factors, but usually a stock buyback is only approved if the firm has run out of good investment opportunities, at least in the short term. Evaluating the best way to use the cash is an art as well as a science and the topic of never-ending debate among finance processionals.
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