Why Do Companies Perform Stock Buybacks?

Investors want to see the values of their investments increase. Usually that means the underlying businesses grow by getting more revenue or making more profit on existing revenue. Better earnings tend to increase the price per share, so each share is entitled to greater earnings and is worth more money on its own.

A public company has plenty of financial tools with which it can increase its value. It has plenty of options for what to do with its profits, too. Some companies pay dividends to shareholders, to distribute part of their profits to their owners. This keeps investors happy. Other companies buy back public shares of their company. Sometimes this technique makes a company more valuable.

Why Do Companies Sell Shares Anyway?

Any public company—any company of which you can buy shares in the stock market—has gone through a process known as an IPO, or initial public offering. The people who owned the company—founders and early investors—sell off pieces of ownership of the company to raise money.

Suppose your family started a maple syrup company in the wilds of Canada. You've worked hard and built up a business worth $10 million dollars. It'll take another $10 million to expand your sales into the United States and the rest of North America. You could raise that money by saving all of your profits over several years, taking out a loan, or selling off part of the company to other investors.

There are good and bad reasons for each option. If you decide to go public, you'll work with a special type of bank to figure out IPO details: what the company is worth (given your plans to grow), how many shares to offer, and the right price for the initial offering. At some date in the future, any investor can use his or her brokerage and buy a share of your company.

Suppose you decided to sell a million shares and keep a million shares for existing owners (you, your family, and your aunt the angel investor). You expect the company to be worth $20 million when the IPO is over. You set the price of each new share at $10 apiece, so you hope to raise $10 million in the IPO.

After all is said and done, your company has its existing $10 million value plus the additional $10 million in capital from the IPO. The million shares you and your family already had are still worth $10 apiece, but there are another million shares out there worth $10 apiece. The value of the company is now $20 million—existing value plus the $10 million capital—but each share holds its $10 value.

Now you have to answer to more owners, but you have the $10 million you wanted to expand your business. Now you can grow your company into a $100 million business with that huge influx of capital.

What is the Value of a Share to an Investor?

Every share you own of a company represents a right to a share of its profits. If your maple syrup business brings in a $2 million profit this year and there are two million shares outstanding, each share is entitled to $1. Over time, the share price of a stock will reflect the value of the business. If you can increase that profit per stock to $1.20 next year and $1.50 the year after that, the price of your stock should increase.

How Does a Company Increase the Profit Per Share?

Obviously it's better to earn more profit per share every year. A business can do this in several ways:

• Sell more products or services
• Increase the price of products or services
• Cut costs and keep more profits
• Reduce the number of shares outstanding

What is a Stock Buyback?

Right now, your little maple syrup company has $2 million in profits with two million shares outstanding. If you made $4 million in profits with the same number of shares outstanding, you'd have $2 in earnings per share.

What if you don't have $4 million in profits? You can still get $2 in earnings per share by reducing the number of outstanding shares. (Stock splits are common. Stock joins are rare. Both techniques change the number of shares outstanding, but they aren't as interesting in this context.)

A stock buyback is where a business buys outstanding shares of stock and then cancels them? Think of every share you sold during your IPO as a strange sort of loan, where you offer a share of profits instead of an interest rate. When the loan is over, you don't have to pay that share of the profits anymore. If your business had money and didn't know what to do with it (buy a new factory, buy a competitor, launch a new line of sugar-free maple syrup, pay dividends), you could use that money to retire those shares.

Sometimes that makes sense.

When Should a Company Buy Back Shares?

Public companies have a duty to use their profits responsibly. Buying back shares makes sense only when that's the best investment the business can make. If you believe you'll get a better return by expanding into fruit syrups, do that. If you believe you'll get a better return by investing in a more efficient factory, do that. If you believe that you'll get a better return by investing that money in something liquid, so you'll have it as cash reserves, do that.

Buying back shares is a good approach when the business believes that its shares are undervalued and there are no better ways to grow the business. Overpaying for a share of the business is as bad for the company as it is for an individual investor.

Not all companies perform stock buybacks, though in the past several years it's grown more popular. (There are solid economic reasons for this, including a demand-side recession in the United States.) Sometimes they make sense. As with any investment, the question of what to do depends on the nature of the underlying business and what other opportunities it has. An untrustworthy company can use a buyback to prop up a flailing business or to raise the price of shares artificially so that corporate officers can unload their stock. Bloomberg View columnist Barry Ritholtz provides more details on when and why you might prefer dividends to buybacks.

Yet in the right circumstances, stock buybacks represent a relatively cheap and easy way to increase the value of a stock. Earnings per share go up, investors see their shares worth a little more, and the business hums along year after year.

← How to Double Your Money | What is a Safe Investment?→