To raise capital and meet expenses, public companies issue common stock. This gives investors the opportunity to benefit from the company's future growth and earnings. The company may elect to redeem (buy back) and cancel shares after issuing them. Depending on how it's done, reducing the "float" of available shares in this way will either help or hurt the price of the stock.
Cancelling Common Shares
The members of a board of directors can authorize the repurchase of shares by the company. The bylaws may require the shareholders to approve this action, as a buyback means spending the company's cash. In order to cancel shares, the company must first redeem them by paying the current price on the public stock exchange. A redemption of shares reduces the number of outstanding "issued" shares available to public investors, also known as the float.
Effect on Earnings
Since redeeming shares reduces the float, it means that company earnings per share will rise, everything else being equal. The trend in earnings-per-share is a vital factor in stock valuation, so buyback in theory should make the stock more valuable. This is the primary reason that companies redeem their shares -- to benefit shareholders, including officers and directors who have an investment in the company, as well as employees holding stock options.
A company may announce a buyback for the benefit of good public relations. A buyback signifies that the business is concerned for the well-being of investors; it also means the company directors feel that the stock is undervalued, and the best use of cash is simply to buy issued shares on the open market. Of course, buying the shares and turning them into company-held "treasury shares" without canceling them has no effect on the share float, and thus no effect on earnings per share.
Canceling shares may not always have positive effects. If a company ties the buyback to a stock split, the buyback and cancellation reduce the number of shares, but the split creates more shares and artificially adjusts the price. In a 2-for-1 split, shareholders get two new shares for every old one they hold, but the price of each new share is only half of the old price. These kinds of financial manipulations can create negative publicity if investors have only a vague idea of the company's goals and intentions. In addition, investors may see a buyback as a waste of company assets, when the better course would be an investment in plant and equipment, research, hiring or other expenses that add value to the company.
- Jupiterimages/Comstock/Getty Images