According to Gallup, 55% of American adults have money invested in the stock market. Thanks to the exponential growth power of compound interest, the stock market can potentially put your money to work in a way that’s hard to match, even with an aggressive saving plan.
But one thing’s for sure: Figuring out how the stock market ticks can be a challenge. There’s a whole wide world of stock market terms to learn, not to mention deciding which shares you want to buy, let alone the “How does it all work?” question that often arises.
If you already have some of that knowledge down and you’re a little further along in your investing journey, you may have heard of the term “stock buybacks,” or even encountered them in your own portfolio.
Here’s a chance to dive in and answer these questions: What is a stock buyback? Why do companies buy back stocks? How does that decision affect shareholders?
A stock buyback is exactly what it sounds like: The company that issued the stock in the first place decides to buy back a number of shares from its shareholders. This might also be called a share repurchase. The immediate effect of the buyback is a reduction of the total number of outstanding shares on the market.
When there are fewer total shares on the market, the value of each share typically appreciates thanks to the laws of supply and demand.
What’s more, each outstanding share left on the market will represent a greater portion of company ownership, which entitles the shareholder to a proportionally greater percentage of its profits.
A company may buy back shares on the open market at the current market price, just like an investor would.
However, it might also present a fixed-price tender offer to shareholders, which usually values the shares at a higher price than the current price per share on the open market.
In other words, if you get a tender offer from a company looking to do a buyback, it may look pretty darn attractive as compared to selling the stocks to other investors.
A tender offer will specify the number of shares the company hopes to repurchase as well as a price range, and shareholders can counter with their own offers, which would include the number of shares they’re willing to give up and the price they’re asking.
When the company has all of the shareholders’ offers, it will decide the right mix to buy to keep its own costs as low as possible.
What Happens to Repurchased Stock?
A company can’t be its own shareholder, so what does it do with repurchased stocks?
It can either list them as treasury stock, which is a stock that can be used to make company purchases or compensate high-level executives, or retire the shares outright.
Either way, the shares are no longer factored into dividend calculations or the earnings per share metric.
Why Do Companies Buy Back Stock?
Selling stocks is a way for companies to raise money and build equity, so why would they want to buy back stocks they’ve already sold?
As it turns out, stock buybacks can be a sound financial move from a business perspective for a number of reasons.
Putting Money Into Shareholders’ Hands
A buyback can be used as an alternative to dividend payments to return cash to shareholders. This method of paying shareholders is typically more resilient to market fluctuations and recessions.
Increasing Stock Value
One of the most common reasons a company might do a stock buyback is simply to increase the value of each individual stock, especially if the company considers its shares undervalued. Increasing stock prices can send a stock chart’s trend line upward, making the asset look more attractive to new investors.
In extreme cases or bearish markets, a company might repurchase stocks with the intention of reissuing them once the market has corrected itself. In this way, it can increase equity capital in the long term without actually issuing any new shares.
Improvement of Financial Ratios
Another way stock buybacks attract more investors is by making the company’s earnings per share (EPS) look much more attractive.
For example, say you’ve invested in Kristin’s Cake Bakery, an imaginary publicly shared company with a projected annual profit of $1,000,000—yeah, Kristin’s cakes are that amazing.
If Kristin’s Cake Bakery has one million outstanding shares on the market, the EPS will be $1 per share. But if the bakery buys back 500,000 shares, that ratio doubles to $2 per share.
A higher EPS can make a stock look more attractive to a potential shareholder and may convince more investors to back Kristin’s Cake Bakery in the future.
Reducing the Cost of Capital
You know what they say: You have to spend money to make money. And that’s the attitude many companies are taking when they create an IPO, an initial public offering, which can be expensive for them.
Although selling shares on the market can help a company earn money to fund growth and projects, it also means that if applicable, the firm is on the line to honor their commitment to those investors, in the form of dividend payments and voting rights.
If a company finds itself at a growth standstill—perhaps because it’s performing extremely well or dominating its field—suddenly, those commitments and shareholders can become an unnecessary burden.
The company doesn’t need the money raised by selling the stocks, and it still has to make regular dividend payments and hold shareholder elections. In those cases, it can make more sense to just repurchase a portion of the shares to mitigate the overall cost of capital.
What Happens If a Company You Invest in Does a Stock Buyback?
If you hold stock with a company that’s announced a buyback, you may be wondering what it means for your investment. Depending on the company’s underlying reasoning and your own portfolio, stock buybacks have pros and cons worth considering.
Shareholder Benefits of a Stock Buyback
For one thing, if you opt into the company’s tender offer, it could mean an opportunity to sell those stocks at a greater value than the market is offering—which could give you more capital to play with for other investments.
And if you don’t sell your shares back to the company and hold onto them, you can likely expect that each share will increase in value since there are fewer outstanding shares on the market. Plus, each share now represents a greater portion of company ownership, which may mean that you’ll see higher dividend payments over time.
A buyback might also mean a lower overall tax burden for you, depending on how long you’ve owned the stock in question. Money earned through a stock market buyback is taxed at the capital gains tax rate, whereas dividends are taxed at your regular bracket level.
If you’ve held the stock for a year or longer, you’ll pay the long-term capital gains tax, whose rate caps out for the majority of earners at 15%—this is likely to be less than your regular income tax bracket. You may also be able to defer capital gains as a result of the share price increase.
Finally, in some cases, a buyback can indicate that a company has so much extra money, they’re straight up not sure what to do with it and buying back stock is the most profitable endeavor they can dream up.
Of course, as mentioned above, this can also mean the company’s found itself at a growth standstill and doesn’t have any current plans for investing that excess capital toward innovative projects, which may or may not have implications for the value of the stock long term.
Shareholder Drawbacks of a Stock Buyback
Although stock buybacks can often be good news for investors, there are some scenarios in which they can be a shareholder detriment.
For example, if a company decides to perform a stock buyback when its stocks are overvalued, this decision can drive down the stock value for shareholders. In this case, paying out dividends could be more favorable for shareholders in the long run, even given the increased tax burden.
Stock buybacks might also be used as a convenient tactic to benefit company executives, who are often compensated by way of stock options. And since some executives earn bonuses for increasing key financial ratios like earnings per share.
Because buybacks are so attractive to company executives for the reasons named above, some companies will go into debt to make large stock repurchases, relying on existing cash flow to repay what is owed.
But if the firm finds itself unable to repay its debts, that could spell bad news for shareholders, and it could decrease the company’s credit rating.
What’s more, those instantly increased financial ratios and values are sometimes a kind of quick-fix scenario, and may not have any lasting impact on a stock’s fundamental value.
For one thing, the company does have to spend cash to perform the repurchase, which can decrease its overall valuation, or net worth. Even with inflated EPS and share values, this decrease can sometimes eclipse the perceived value increase shareholders see immediately after a buyback.
Unfortunately, you might not be able to tell what exactly a company’s board of directors is thinking when they announce a buyback; but overall profitability and other financial metrics can help you get a better sense of the whole picture, especially if you’re still in the research phase and don’t yet own any of that company’s stock.
Ready to Get Started on Your Own Investment Journey?
Just like almost everything else to do with the stock market, stock buybacks aren’t exactly simple. But once you understand the basics of how they work, you can feel more confident in making decisions about your own portfolio, whether that means participating in a tender offer or factoring in a recent buyback when evaluating whether a stock is worth purchasing.
From choosing the first stock you’ll add to your portfolio to learning more about diversification, tax implications, and more, investing is a journey. And with a little bit—okay, a medium bit—of research and a dash of luck, that journey might lead to some financial confidence.
Of course, even if all of that research sounds daunting, it doesn’t mean you have to skip out on investing entirely. With SoFi, you can choose between active and automated investing—and you’ll have the opportunity to speak one-on-one with SoFi’s financial advisors.
If you go for an active investment account, you get to decide which stocks you want to buy and sell—and you’ll pay zero in SoFi transaction fees. SoFi’s automated investing platform, on the other hand, can help you create a time-targeted, diversified portfolio based on real human research and top-of-the-line computer algorithms, all with minimal effort on your part—and zero management fees!
Curious about how SoFi might help you invest in your future? Learn more about SoFi Invest®.
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