Buyback (Stock) - Explained
What is a Stock Buyback?
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Table of ContentsWhat is a Stock Buyback?How Does a Stock Buyback Work? How Firms Buyback their SharesAcademic Research on Stock Buybacks
What is a Stock Buyback?
Buyback, commonly known as share repurchase, takes place when an organization tends to reduce its number of shares issued in the market by buying outstanding shares on its own. There can be a lot of reasons that firms buyback their shares including boosting the value of left over shares by decreasing their supply, or not allowing shareholders to have a controlling share in the company.
How Does a Stock Buyback Work?
By using the buyback approach, a company invests in its own shares, or in itself. By making a reduction in the number of outstanding shares in the market, the company makes an increase in the portion of shares that investors or shareholders own. When a companys shares are undervalued in the market, it may follow the buyback strategy and offer returns to its investors. Due to the bullish nature of the company, buyback results in increasing the amount of earnings for every share. And, it helps in increasing the stock price, provided price-to-earnings ratio is consistent. The share repurchase or buyback brings a decline in the quantum of shares issued in the market, thereby, increasing the value of each share in the company. While the earning per share (EPS) and the price of stock rise, the price-to-earning ratio declines. Buyback is a way of giving assurance to investors that the company has created reserves for meeting contingent situations, and to fight economic issues, if any. Companies may follow buyback policy for compensating their employees and managerial team with financial incentives including stock options and stock rewards. After buying back their own shares, companies issue them to their employees and management. This approach also enables to retain the position of current shareholders of the company. It is important to note that as companies utilize their retained earnings to buyback shares, the ultimate economic benefit offered to investors will be similar to the case when dividends were issued from the company's retained earnings.
How Firms Buyback their Shares
A company can use the buyback option in the following ways:
- Companies can tempt its existing shareholders with a tender offer in which they are given the option to tender (submit) at least a specific portion of their shares in a given period of time. In order to make the deal attractive, companies offer a premium amount that is more than the existing market price. The premium amount is offered so as to avoid shareholders from holding on to their shares in future, and submitting them now.
- Some companies prefer buying back their shares in the open market, and tend to design a specific share repurchase agreement that involves buying shares at specific periods of time or on constant basis.
A firm can fund buying back of shares with debt, that can be either through cash flow from the operational activities, or cash in hand. An expanded share buyback refers to the improvement in the current share repurchase program of a company which results in a steadier decline of its share float. The size of the expanded share buyback has a positive impact on the market, and vice-versa. The expanded buyback, having a huge magnitude, tends to increase the share price. Buyback ratio is calculated by dividing the amount of buyback shelled out in the last year and the value of market capitalization at the time when buyback starts. This helps to strike a contrast regarding the prospective effect of repurchases among various organizations. It also informs about how quickly the company will be able to offer returns to shareholders, and to what extent. As per the statistics, the organizations who keep buying back their shares on an ongoing basis have benefitted from market conditions.
Academic Research on Stock Buybacks
- The Buyback Anomaly on the Polish Capital Market, Szyszka, A., & Zaremba, A. (2011). The Buyback Anomaly on the Polish Capital Market.Finanse, Rynki Finansowe, Ubezpieczenia, (38), 481-494. A number of studies carried on the US data found positive long-term excess returns following buybacks. The aim of this paper is to verify if a similar anomaly can be observed on the Polish market. We confirm the existence of long-term abnormal returns following buybacks and excess profitability of the buyback mimicking strategy (i.e. buying stocks after repurchase announcements). We discuss potential sources and present various interpretation of our evidence. Among others, we propose an alternative behavioral hypothesis for abnormal post-buyback returns. We show circumstances under which post-buyback outperformace might be also a result of managerial biases at the time of the repurchase and later temporal market overreaction in the post-buyback period.
- Information disclosure, CEO overconfidence, and share buyback completion rates, Andriosopoulos, D., Andriosopoulos, K., & Hoque, H. (2013). Information disclosure, CEO overconfidence, and share buyback completion rates.Journal of Banking & Finance,37(12), 5486-5499. An open market sharebuyback is not a firm commitment, and there is limited evidence on whether firms repurchase the intended shares. Unlike US studies, we use data from unique UK regulatory and disclosure environment that allows to accurately measure the share buyback completion rates. We show that information disclosure and CEO overconfidence are significant determinants of the share buyback completion rate. In addition, we find that large and widely held firms that conduct subsequent buyback programs and have a past buyback completion reputation exhibit higher completion rates. Finally, we assess whether other CEO characteristics affect buyback completion rates and find that firms with senior CEOs who hold external directorships and have a longer tenure as CEO are more likely to complete the buyback programs. In sum, our results suggest there is a clear relationship between information disclosure, CEO overconfidence, and buyback completion rates.
- Upgrades, tradeins, andbuybacks, Fudenberg, D., & Tirole, J. (1998). Upgrades, tradeins, and buybacks.The RAND Journal of Economics, 235-258. We study monopoly pricing of overlapping generations of a durable good. We consider two sorts of goods: those with an active secondhand market and anonymous consumers, such as textbooks, and those with no secondhand market and consumers who can prove that they purchased the old good to qualify for a discount on the new one, such as software. In the first case we show that the monopolist may choose to either produce or repurchase the old good once the new one becomes available. In the latter case we determine when the monopolist chooses to offer upgrade discounts.
- Buybacks, exit bonds, and the optimality of debt and liquidity relief, Froot, K. A. (1988). Buybacks, exit bonds, and the optimality of debt and liquidity relief. We compare various forms of market-based debt relief with coordinated debt forgiveness on the part of creditors. These schemes lead to different allocations of resources and levels of debtor and creditor welfare, but all attempt to stimulate debtor investment through reductions in the level of debt. If investment-incentive effects are present, then investment in liquidity-constrained debtors will respond by enough to make a reduction in debt profitable, but not by enough to make the reduction in debt optimal. For these countries the optimal debt-relief package (from the creditors perspective) will include an infusion of new lending.
- Countertrade, offsets, barter, andbuybacks, Cohen, S. S., & Zysman, J. (1986). Countertrade, offsets, barter, and buybacks.California Management Review,28(2), 41-56.
- Sensible buybacks of sovereign debt, Detragiache, E. (1994). Sensible buybacks of sovereign debt.Journal of development Economics,43(2), 317-333. Sovereign debt is not prioritized, and creditors share the costs of a default in proportion to their exposure. Equal-sharing insures that all creditors cooperate in imposing default sanctions, but it leads to excessive borrowing. Countries that borrowed too much because of equal-sharing can gain from debt buybacks, even if there is no debt overhang. Sensible buybacks should be accompanied by either an interest rate reduction or a new money provision, they should grant unsold debt seniority over new loans, and they should assign future debt renegotiation to a third party.