Question

Explain what is meant by stock buyback. Your answers need to include: (a) The motivation of the company to conduct a stock buyback? (b) When (in what situations) does the company possibly buy back their stock? (c) The expected impact of a stock buyback on the company's stock performance?

Answer 1

Stock buyback means buying of common shares of one's company back from the market. This repurchase of shares represents a more flexible way to return money to shareholders. As a result of buyback, the number of outstanding shares in the market reduce.

A. There can be different motivations to conduct a stock buyback. If the company thinks its its stocks are priced cheaply then it might want to buyback its shares. When the stocks become undervalued, buyback helps signal the market that this is the bottom of prices. It shows that company management thinks that the value should be higher. Thus, the company reinvests in itself. Also, the management may think that buyback is the best use of capital. When number of shares are reduced, the Earnings per share (EPS) increases (because denominator reduces). Thus P/E ratio also becomes attractive. Again, buybacks can be tax effective way of rewarding shareholders.

B. When a company doesn't have good avenues for investment, it doesn't know what to do with the cash at hand, when it wants to improve ratios and valuation of the company, when the promoters want to consolidate their holdings, in all such situations the company would like to buyback its shares. As the number of shares het reduced, relative ownership of each investor increases.

C. As said the EPS of stock increases and P/E becomes attractive. Buyback is also a way of giving cash to shareholders like dividends. Ratios like ROA and ROE also improve as denominator reduces. The signals company send to stock market by buying back typically gives a boost to share price. Such confidence of management on its firm is often rewarded by increasing price of shares.