A stock buyback occurs when a company purchases shares of its own stock. Usually, a stock buyback is executed gradually through regular purchases of company stock on the open market. Occasionally, a company might buy back shares of its stock through an arranged transaction with a large stockholder. Stock buybacks do not reduce shareholder equity. They increase it.
Equity means ownership. If you own stock of a company, you have equity in the company. Each share of stock represents a percentage of ownership in the company. If a company buys back stock, it reduces the amount of outstanding equity. As an existing shareholder, your percentage of ownership in the company increases, since the company is now divided among a smaller number of shareholders.
When a company buys back stock, it retires the purchased shares and reduces the amount of outstanding stock. The company's earnings have not changed but the amount of existing stock has decreased, so a stock buyback can result in an immediate increase in earnings per share. Because earnings tend to drive stock prices, an increase in earnings due to a stock buyback can result in a higher share price. A stock buyback can also give a psychological boost to investors because it reflects management's belief that the company is undervalued and worth purchasing at the current share price.
As a shareholder, the main benefit you hope for after a stock buyback is an increase in share price. If the company you own pays a dividend, it's possible your dividend could also increase, as the company pays out the same total amount of dividends over a smaller number of shares.
Alternatives and Consequences
If a company spends money to buy back stock, it is using capital resources that could have been spent differently. While a stock buyback can increase corporate earnings, it's possible that the money could have generated an even higher return through the purchase of another company or an investment into additional production facilities. In some cases, a company overestimates its own value and overpays for the stock. If a company overspends in a share repurchase program, it may not have sufficient cash to continue paying out a dividend.
After receiving a Bachelor of Arts in English from UCLA, John Csiszar earned a Certified Financial Planner designation and served 18 years as an investment adviser. Csiszar has served as a technical writer for various financial firms and has extensive experience writing for online publications.