A share buyback, or share repurchase, is when a company purchases its own shares from existing shareholders.
While share buybacks and dividends are both mechanisms for firms to return money to shareholders, they have several important differences. Share buybacks reduce the number of shares outstanding; dividends do not. Earning per share therefore increase with share buybacks but not with dividends. Share buybacks and dividends are subject to different tax rates. While share buybacks are taxed at the capital gains rate, dividends are taxed at marginal income tax rates, which tend to be higher than capital gains rates. Further, investors do not incur taxes on capital gains until they sell their shares. Finally, managers perceive repurchases to be more flexible than dividends. Repurchases fluctuate with earnings while "sticky" dividend payments remain relatively stable. Managers' strong preference to maintain dividends may be a result of investors reacting more negatively to dividend cuts than repurchase suspensions.
Firms buy back stock to return cash to shareholders. For this reason, repurchases are often considered a substitute for dividends. In theory, returning cash to shareholders is a good thing because it reduces the “agency costs” of free cash flow. Agency costs arise due to the separation of ownership and control. (Shareholders own the firm. Managers control it.) Shareholders may be concerned that managers will not be good stewards of their money. For example, managers may overpay themselves or take on projects that personally benefit them without benefitting the owners of the firm (the shareholders). Returning unneeded cash to shareholders keeps agency costs to a minimum.
Another reason firms buy back stock is to signal good news to the market, particularly that the firm expects future cash flows to be greater than those reflected in the current stock price. Signaling stems from the fact that firm insiders know more about the firm’s prospects than outsiders. Managers, who are firm insiders, may know before outsiders about launching a new product line or an upcoming merger. In addition to having more or better information, insiders may be better information processors. Insiders’ unique knowledge of firm procedures and of their industry may give them an advantage over outsiders when factoring new information into stock price. If managers believe the current stock is too low, they may signal undervaluation using share buybacks. In fact, many buyback announcements include claims that the firm’s stock is undervalued at its current price.
A more nefarious reason for buying back stock is to boost earnings per share. Since share buybacks reduce the number of shares outstanding but only minimally impact earnings (mainly through lost interest on cash), earning per share increase after a buyback. There is some evidence that firms use buybacks to manipulate earnings per share. It tends to be at the margin, however. Research points to firms buying back stock when earnings per share fall right below analyst consensus forecasts. These firms are more likely to repurchase to boost earnings per share by a small amount, say one penny, to meet analyst forecasts. (“Meeting” earnings refers to reporting earnings per share that equal the analyst consensus forecasts. “Missing” earnings means earnings fall below this threshold, and “beating” earnings means earnings are above it.)
A common misperception about share buybacks is that they mechanically boost stock price because repurchases reduce shares outstanding. While it is true that repurchases reduce the number of shares, it is also true that repurchases reduce the company’s cash holding and therefore assets or, if financed with debt, increase the company’s liabilities. A reduction in assets and an increase in liabilities both decrease shareholder’s equity. This decline in shareholder’s equity is proportional to the decline in shares outstanding.