What Is a Share Buyback? Definition, Benefits and Challenges

By Indeed Editorial Team

Published 30 April 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

Share buybacks are a common occurrence in the stock market. They can help a company increase the value of its stocks and show its strength in the market. Understanding what a share buyback is can be useful if you decide to pursue a finance or business-related career. In this article, we discuss what's the definition of a share buyback, show how it can be valuable and explain why a company may buy its own shares.

What is a share buyback?

A share buyback, also known as a share repurchase, is when a company reacquires its own shares from the stock market. This may occur when the company has additional profits or when there's extra money to spend on investments. The company may buy its shares, effectively removing them from the stock market, and may either reserve them to sell back at a higher price later or offer them as equity to their employees.

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Why would a company buy its own shares?

There are several reasons why a company might seek to reacquire its own shares. A common purpose of share repurchasing is to increase a stock's value, though a company may also intend to offer stock ownership options to its employees. Some primary reasons a company might facilitate a buyback are:

Increase profit from up-trending stocks

Once demand increases for a certain stock, the value of the stock increases as well. For example, if a company has 50 shares available for $5 apiece and they purchase half of those stocks, only 25 shares are available on the market now. If this buyback increases the individual stock value from $5 to $10, due to the scarcity of the stocks, that means the company might be able to reap additional profits from the increased stock value alone.

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Push stock value up

Completing a buyback of shares may increase the earnings per share (EPS). When shares become unavailable in the market, it increases demand for the stock, which propels other investors to buy as well. As stock becomes less available, the value goes up. Because of this, a company may buy its own stocks if they believe they have undervalued stocks. Depending on the number of available shares, buying half can potentially double the stock value.

Increase potential capital elsewhere

Offering stocks to shareholders can be an efficient way to expand a business, though a company may want to advance their growth potential through other methods as well. This is because a company pays shareholders for the cost of equities. If a company has too many shareholders, they may choose to buy their stocks back and invest the money they save in the process elsewhere.

Offer equity to its employees

Many companies now offer stock ownership incentives to their employees. In some cases, a company's majority shareholders may be the people who work there. For a growing company with a positive financial forecast, this may mean a high value benefit overtime. In the case of a well-established company, this can attract new applicants and motivate current team members to buy in.

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Advantages of buying shares

The company may develop a buyback strategy to offer improved benefits to its employees or drive investor interest. If a company plans their buyback well, they may experience a high value of return on its investment. It may motivate employees or bring in additional profits to the business. A few other potential advantages include the following:

Promote financial health of the company

Companies typically facilitate a buyback when they believe they have undervalued stocks. To potential investors, this may appear as an opportunity to buy in early while the prices are still relatively low. There are many investors who examine the stock market for early opportunities and may see a buyback as evidence of an increase in stock value. Investors may also see it as a sign of financial health because of the revenue companies use to buy the stocks. A buyback can only occur if the company has disposable income, which investors may acknowledge as a positive sign.

Increase value for existing investors

A company purchasing its own available shares can push individual share costs upwards. This might be to the benefit of investors who had purchased stocks beforehand. An increase in share price equates to larger profits and improved buying power in the market overall. If investors see their profits increase, it may encourage them to keep their stocks or purchase more.

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Potential drawbacks of buying shares

While having the potential for several advantages, buybacks may also result in a few disadvantages. For example, either the company or its investors may become affected by the reduced available equity in the market. To avoid drawbacks, it might be helpful for a company to consider all possible outcomes before facilitating a purchase. Identifying disadvantages gives the company a chance to pursue better options. Some possible disadvantages include:

Affecting investors

A price increase may occur after a buyback, though a decrease is also possible. If the stock prices decrease afterward, it may hint that there are weak points in the company's financial health. Additionally, continuous purchasing of stocks may lead investors to assume that the company has no other growth opportunities.

Altering financial health

If the price of the stocks decrease, the company may lack the additional profits required for other purchases. This may alter the overall financial health of the company and prove challenging in the case of future business decisions. The company may reevaluate its finances or face other unexpected changes in its structure. Additionally, if the company has to finance the purchase through a loan, it may affect the company's credit rating.

Affecting investment plans

A company typically purchases its stocks to gain a higher value in future equity prices. Unforeseen changes in the market overall may present possible challenges for the company's expectations. For example, if the stock market's value drops after the stock purchase, the share price may be less than what the company projected. In this case, the company may resort to finding alternative ways to recoup on its investment.

Types of shares available for purchase

Shares are units or percentages of ownership in a company. Only the shares of a public company are available for purchase on the stock market. Shareholders are the individuals who purchase available stocks and own portions of the company. They become a part of business decisions and can benefit from future profits. There are two types of shares available for purchase:

Equity shares

Equity shares, also considered ordinary shares, are the standard units of stock available on the market. When an individual owns equity stock, it gives them the ability to vote on company decisions. This role has a higher involvement than an ordinary shareholder, who only obtains payments from the company's profits. An equity shareholder may receive communication from the company electronically or through the mail, prompting them to cast their votes on important changes.

Preference shares

These stocks offer a greater number of benefits to their shareholders when it comes to company profits. They typically receive share profits earlier than ordinary shareholders and receive priority for first payment in the event of a company liquidation. While these shareholders may have a higher profit potential, only the equity shareholders receive invitations to vote on company decisions. There are three types of preferential shareholders:

Cumulative preference shareholders

A cumulative preference shareholder may receive dividends before the company pays them to the remaining ordinary shareholders. This can occur when the dividends arrive late. For example, a company may only pay dividends to its shareholders during a profitable year. They may delay those payments if financial challenges arise during a particular year. In the following year, they usually pay cumulative preference shareholders first, prioritising them for outgoing payments.

Non-cumulative preference shareholders

Non-cumulative preference shareholders only collect dividends during the years when a company is making a profit. This means that if a company doesn't have a decent profit margin, then the cumulative preference shareholder is the only shareholder who is eligible to receive a payment. For example, if a company misses its profit margin for one year and makes a profit in the following year, this type of shareholder can only receive payment for one year.

Convertible preference shareholders

The convertible preference shareholder can alter their share type into an equity share. While this first requires company approval, only a convertible shareholder has that option. For example, if the shareholder gains a higher interest in the company and wants to take on a more involved role in its future decisions, they may elect to change the type of stock they own for a chance to have a larger involvement with the business.

Related: A Guide to Non-Controlling Interest (With Examples)

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