Why Are Companies Buying Back Their Stock?

By Brittany N. Cox 
Registered Investment Advisor at Nestlerode & Loy Investment Advisors

There is not a lack of news articles about companies buying back their own stock or the government arguing about a company buying back their own stock. Lately, I’ve had a few friends ask me what is a stock buyback and why would a company want to buy their own stock?

According to Investopedia, a stock buyback is the repurchase of shares of stock by the company that issues them. It occurs when the issuing company pays the shareholder the market value for the shares and re-absorbs that portion of its ownership that was previously held by public or private investors. A stock buyback can take place on the open market or from the shareholders directly. The recent trend is that the share buybacks are overtaking dividends as a preferred way to return cash to shareholders.

Typically, when people see the news of a buyback, they associate it as a negative action by the company because it seems that since the company sold the shares of stock to raise capital, they are counteracting by giving that money back. However, stock buybacks happen for many reasons and some of those reasons could be beneficial to the company. From the company standpoint, outstanding shares represent ownership in the company and those shareholders get to vote on company policy and financial decisions. If the business sold shares to expand and grow the company, and believe they have reached the end of their growing stage, they may wish to rein in the ownership and buy back some of the shares. This also saves them on the dividend payments their shareholders expect.

Also, one of the goals of the company executives is to maximize their shareholders’ wealth, normally through a steady stream of dividend payments. Another reason companies favor a buyback over increasing dividends is to preserve the price of the stock. If a recession hits and the company needs to cut back on dividends, the stock would suffer from a sell off. However, if the company just bought back fewer shares and kept the dividend payments, the stock price would likely take less of a fall.

Still another reason a company would buy back its stock is because they feel their shares are undervalued. A stock can be viewed as undervalued for a variety of reasons such as short-term business performance, news items that present the public with a bad feeling, or just a bearish sentiment in general. In this case, the companies prefer to invest in themselves by repurchasing shares in hopes to capitalize when the stock begins to rise again when the company starts to present positive results or public sentiment improves. When the stock begins to rise, sometimes the company will re-issue those shares at the higher price and profit from the sale. This raises equity for the company without diluting ownership any further.

A stock buyback sounds beneficial to the company, but what about the overall economy? Stock buybacks usually happen when the overall economy is positive, and they generally have a positive effect on the economy. They usually lead to increasing stock prices and research shows that increases in the stock market have a positive effect on consumer confidence. However, there are a few politicians who feel stock buybacks should be banned. They believe that a stock buyback only provides a benefit to company executives and hurt the common stakeholders of the shares. They are worried that, in the corporate world, the salary of company executives is based on the share price of the company stock which is putting a bounty on getting the share price as high as possible. Also, some analysts feel this hurts investors by hindering the long-term investors’ growth and dividends, since the investors who sell their shares back to the company benefit from buybacks.

While there are many ways to look at a stock buyback, it seems that their increasing popularity is a good sign for the overall economy. Companies have a more positive outlook on their financial situation, so they are buying back their shares. Firms that buy back shares tend to outperform or at least match the S&P 500’s performance over the long term. So, while it’s easy to hear the senator’s arguments about companies paying their employees more or investing in research and development instead of buying stock, we must keep in mind the behind-the-scenes decisions being made for the long term well-being of the company.