Companies have been known to repurchase their own shares when the company’s stock price has fallen significantly. When this occurs, it's a way for management to express that they believe that the stock is undervalued. More importantly, it can push the stock price higher. The gains, however, can be short lived.
Suppose company ABC has one million shares outstanding and a stock price of $100. The company's stock price has fallen significantly over the past year. As a result, management decides to implement a share buyback program. They issue debt to fund the program and over the next several months, buy up 20 percent of the shares outstanding. When the buyback program is complete, there will be 800,000 shares outstanding. In theory, the stock should be trading higher.
If the company earned $1 million per year, or one dollar per share before the buyback, it now earns $1.25 per share post buyback ($1 million/800,000 shares = $1.25). Now, when investors buy shares of stock, they earn $.25 more per share. The value of the stock should adjust upward to reflect this. The pop in price from a share buyback may be short lived, however. The company may have borrowed money to fund the buyback which means the company now has the added expense if servicing the debt. This can impact earnings. If the company simply used its existing cash on the balance sheet to fund the buyback, it is reducing its liquidity which could affect the company’s value.
Share buybacks can move a company's stock price higher but make sure the company has sufficient cash to fund the buyback. Otherwise the impact could be short lived.
Reuben Advani is the president of The BARBRI Financial Skills Institute and the author of two finance books. More information on this and other topics can be found at http://legalpractice.barbri.com.