Stock buybacks, also sometimes known as share repurchases, are a common way for companies to pay their shareholders. In a buyback, a company purchases its own shares in the open market. Doing so decreases the number of shares held by the public, thereby increasing the ownership stake of each remaining shareholder and -- hopefully -- the share price.

Stock buybacks vs. dividend payments

Both buybacks and dividends are options for a company that wants to "return value to" or "reward" its shareholders. But there are some important differences between the two methods.

Dividend payments usually contain an implicit promise that the company will try to maintain or raise the dividend over time. Buybacks allow a company to reward shareholders without tacitly committing itself to repeating that largess in years to come.

Buybacks can also be more lucrative for corporate executives than dividends. Managers who are compensated via stock options rather than company stock don't receive dividends, but they can benefit from a buyback that pushes up the near-term or long-term stock price.

Buybacks can also be lucrative to shareholders if the company's stock is undervalued when it's bought back. But if the stock is overvalued, buybacks can be a waste of money. You'll often see companies buy back lots of stock when earnings are good -- and stock prices high -- only to be forced to reduce buybacks, and even sell stock, when losses are piling up, and share prices are low. Needless to say, buying high and selling low is exactly the opposite of what long-term shareholders want.

How does a stock buyback affect the price?

A buyback reduces the number of shares in a company held by the public. Because every share of stock is a partial share of a company, the fraction of that company that each remaining shareholder owns increases.

In the near term, the stock price may rise because shareholders know that a buyback will immediately boost earnings per share. Over the long term, a buyback may or may not be beneficial to shareholders. Here's an example of how it works.

In 2013, McDonald's bought back 18.7 million shares for $1.8 billion dollars -- an average price of $96.96. Without the share buyback, McDonald's would have finished the year with 1,008.7 million shares outstanding. Each shareholder thus ended that year owning a 1.8% greater share of the company than they would have otherwise.

With fewer shares out there, earnings per share increased. Book value per share decreased -- while each shareholder got a bigger share of the pie, the pie itself became smaller when McDonald's spent a lot of money on the buybacks.

McDonald's FY 2013 Metric

With Buyback

Without Buyback*

Earnings per share



Book value per share



Data source: Standard and Poor's Capital IQ. *Approximate based on author's estimates.

Will the buyback make shareholders better off or worse off? It depends upon whether the company got a good deal for its money. In other words, long-term shareholders hope the company paid a price that was lower than the stock's intrinsic value.

Comparing McDonald's' share buybacks with its stock price from 2006 through 2015 suggests that the McDonald's' buybacks have done well for shareholders, because they occurred at much lower price points than the long-term future price.

(Now that you know what happens when companies buy back stock, you might be interested in buying some shares yourself. For that, you're going to need a brokerage account, if you don't already have one. The Fool has a great section where you can learn about various brokers, and figure out which one is the best choice for your investing needs.)

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