Are BuyBacks Good? – Pros And Cons Of BuyBacks For Investors

Are BuyBacks Good? - Pros And Cons Of BuyBacks For Investors

What is a Buyback?

Before determining whether buybacks are good for investors, first things first, knowing what a buyback is should be essential — pretty much, when a company decides to buy their own shares back it is known as a Buyback.  This will reduce the number of available shares on the market, thus increasing the value of any shares still outstanding and held by shareholders.

Why do companies buy back their shares?

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Companies may decide to buy back their shares for several reasons, if they have a lot of cash on hand and have nowhere else to invest it, or they want to increase their ownership and voting power in their company.  Often times public companies’ main goal is to provide value to shareholders, and when they buy back shares in their own company it increases the value of the remaining shares available by reducing the supply.

A company may also feel their shares are undervalued at any given moment and decide to do a buyback providing investors with a return.  Buybacks usually signal to investors the company is healthy and has enough cash set aside in case of emergencies, and they believe in the long-term prospects of their organization.  Buybacks often give investors confidence in their stock and may make them want to buy more themselves also increasing the price of the stock.

In addition, a buyback can be used for compensation purposes.  Often times you will see companies give employees, and especially management with stocks and stock options as a reward.  Instead of diluting the ownership of existing shareholders (which is bad), they will do a buyback and then issue out those shares to their employees.

Why are buybacks bad?

While there are many positives to buybacks, there is also criticism and reasons it can actually be a bad thing.  First off, when the government decides to give big tax breaks to companies, and instead of investing the money in people, infrastructure, or other ways to grow the business, they aren’t really stimulating the economy, which the government had hoped.

When companies do a share buyback, it is indicating to investors that they do not have any other profitable opportunities for actually growing the company and increasing long-term value.  Also repurchasing shares can put a company in a tough position if the economy falls into a recession and they face financial issues, that they can no longer cover because they spent their cash on buying back shares.

Since buybacks are done by using the firms retained earnings, they could have just paid out a dividend to investors having the same net economic effect, but actually putting cash in the hands of shareholders in which they can use to possibly buy things and stimulate the economy.

Why are Buybacks good?

Many investors do actually like buybacks as it is a way for their stocks to increase in price since it is reducing the number of shares available, and making the current shares outstanding more valuable.

While it may indicate a company has nowhere else to invest the money, if the company is a mature blue-chip stock, it can be looked at as a positive sign, showing the company is very stable and investors may believe in the long-term prospects of their organization.  Especially when bad news has come out and the price of a stock has dramatically declined, a buyback will help increase investor confidence.

Share repurchases reduce the number of existing shares, making each outstanding share worth a larger percentage of the corporation.  This essentially increases the earnings per share (EPS) and Price-to-earnings ratio (P/E) decreases making the stock price increase.  It is also a good sign that the company has enough cash on hand to do a buyback, compared to a company in financial trouble that may have to issue more shares that will dilute the ownership for current owners having the opposite effect as a buyback.

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