A stock buyback (or share buyback) is a process whereby a company buys its own shares on the stock market and cancels them. The act of buying back shares has two effects, first, it reduces the number of outstanding shares a company has and secondly, it increases the company’s earnings per share. Whilst share buybacks can decrease the liquidity of a company’s stock, it does have long-standing benefits for shareholders.
A company might decide to buy back its shares if it feels that its stocks are undervalued on the stock market. By buying back its shares, the company increases the perceived value of those shares. It also sends a signal to the market that they themselves think that the best use of their capital is to invest in themself.
Stock Buybacks Increase Earnings Per Share (EPS)
As mentioned earlier, one of the effects of buying back stock is that of an increase in the company’s earnings per share (EPS). This occurs because of how the EPS is calculated. This could cause the stock price to increase as investors typically compare earnings reports and respond accordingly. The good thing about a stock buyback is that it will have a long-standing impact on all future income statements. It does not just give a momentary bump in earnings.
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Possible Increased Dividends
Another consequence of a stock buyback is that it affects dividends. If a company buys back its stock it will mean there are fewer shares for dividends to be divided amongst when they are declared. This could mean a higher payout for shareholders if the company decides to pay the same amount following the buyback as it did before.
A reduction in liquidity is often posited as a negative result of share buybacks. However, there is another way to look at it. Though a share buyback reduces liquidity, it can benefit the shareholder. Reducing the number of shares outstanding has a direct impact on the supply-demand relationship of the stock.
If there is exceptional news about the company then having fewer shares outstanding will mean that prospective buyers of the stock wanting the shares might have to bid higher in order to incentivise sellers. As per the law of supply and demand, something that is in great demand with limited Supply will command a higher price.