Profitable companies have several ways to return excess cash to their shareholders. Dividend payments are probably the most common way, but a company can also choose to engage in a share-buyback or share-repurchase program. Both terms have the same meaning: A share repurchase (or stock buyback) happens when a company uses some of its cash to buy shares of its own stock on the open market over a period of time. 

Below, we'll look at how share-repurchase programs work, why a company might choose to buy its own stock, and how these share-buyback programs affect investors.

An assortment of colorful common and preferred stock certificates.

Image source: Getty Images.

Why would a company repurchase its own stock?

In the U.S., public companies are generally managed with a goal of maximizing return for shareholders. With that in mind, a company that is generating more cash than it needs to fund its own operations and investments might choose to return that excess cash to its shareholders. Dividends -- periodic cash payments to shareholders -- are a well-accepted way to do that, but they're not the only way.

Sometimes a company's board of directors decides that the excess cash is best spent on buying the company's own stock. There can be several reasons to make such a decision:

  • The board might feel that the company's stock is undervalued, making it a good investment. Investors often perceive a buyback as an expression of confidence by the company.
  • If the excess cash is a windfall, the company may not want to commit to paying a dividend (if it doesn't already) or to increasing its existing dividend on an ongoing basis (if it already pays a dividend). An ongoing dividend can burden a company during lean times if it's maintained, and leave investors upset if it's cut. 
  • The company's large shareholders may not want the extra tax burden of an increased dividend. Unlike dividends, share-repurchase programs don't have immediate tax implications for shareholders, as there's no payment to investors. 
  • The company may wish to offset the dilution caused by generous employee stock-option plans. Companies in fast-growing industries may find themselves in a tight labor market; those companies often issue stock options to recruit and retain talented employees. Over time, as those options are exercised, the company's total number of shares outstanding will rise, diluting existing investors. A buyback can offset that effect.

How does a stock buyback impact shareholders?

Stock-buyback programs differ from dividends in that there's no immediate, direct benefit to shareholders: With a dividend, shareholders get cash.

But shareholders do benefit indirectly from a buyback or repurchase program, as the goal is generally to raise the company's stock price. The idea is that by taking shares out of circulation, the remaining shares will be worth more. Think of the company's overall value as a pie: If it's cut into fewer slices, each slice will be bigger.

Of course, it doesn't always work out exactly that way in practice. On one hand, just the announcement of a share-repurchase program is sometimes enough to give the stock a boost, before the company has bought any shares. 

On the other hand, sometimes there's unfavorable news or a shift in the market while the company is in the process of buying its own shares. In that case, its shares might trade lower for a while even thought the total number of shares outstanding has been reduced by the buyback. 

Generally speaking, though, a share-repurchase program will tend to boost the stock's price over time. That's not just because of the reduced supply of shares, but because buybacks tend to improve some of the metrics that investors use to value a company.

How do share repurchases affect valuation?

Share buybacks reduce the company's total number of shares outstanding and the total amount of cash on the company's balance sheet. Those changes affect several metrics used by investors to estimate the value of a company

Once shares are repurchased, they are generally either cancelled entirely -- wiping them out of existence -- or kept by the company as treasury shares. (Treasury shares are counted as issued shares, but not as outstanding shares.)

Reducing the number of shares outstanding affects calculations such as earnings per share, which in turn affects a widely used valuation metric, the price-to-earnings ratio. If total earnings stay constant, but the number of shares outstanding falls after a buyback, the company's earnings per share will rise. Taking that one step further, if the company's stock price stays constant but earnings per share rise, its price-to-earnings ratio will fall. 

Buybacks also reduce the amount of cash on a company's balance sheet. That in turn increases return on assets, because the company's assets (cash) have been reduced. Return on equity will also rise, because there's less outstanding equity. 

Are there drawbacks to share repurchases?

While a company's share repurchases are generally intended to be bullish for its stock price, there are sometimes reasons for concern. 

Critics often contend, with some justification, that companies tend to repurchase shares after a period of success, when they have plenty of cash. This means that the company is repurchasing its stock at a high valuation. A company in that situation could end up buying its shares at a cyclical price peak, getting fewer shares for its money -- and leaving it with less cash in reserve when its business slows.

Investors should also proceed carefully if the buyback appears motivated by management's desire to improve its valuation metrics (or put another way, to manipulate them). A company that uses buybacks to create the appearance of quick growth in earnings per share, for instance, may not be a company worth owning.

Are share buybacks good or bad?

As with many things in investing, the answer isn't clear-cut. If the company genuinely has cash to spare, and its shares are arguably undervalued, then a buyback can be a good way to generate benefits for shareholders. But if its shares are expensive, it's worth asking why the company isn't choosing to pay a special dividend to its shareholders instead -- or hanging on to the cash for a rainy day.