'Stock Buybacks' is explained in detail and with examples in the Trading edition of the Herold Financial Dictionary, which you can get from Amazon in Ebook or Paperback edition.
Stock buybacks occur when companies repurchase their own company shares from the markets. They are sometimes called share repurchases. A buyback is like a company choosing to invest in itself, since it is actually employing its own cash reserve to purchase its own stock.
Companies may not be shareholders in themselves, which means that their shares are absorbed back into the company. This has a net effect of decreasing the quantities of stock share which are outstanding. This also increases the size of each owner’s stake in the company as there are not as many shares and claims on the company’s earnings.
There are two means in which stock buybacks occur. They can be done via tender offers or open market purchases. In a tender offer, all shareholders receive such a tender offer from the company to submit some or all of their shares by a specific deadline. Such an offer divulges the quantities of shares which the company wishes to buy back as well as the price range they are agreeable to offer.
These tenders are nearly always at premium prices versus the current market level. Investors who are interested in participating will let the company know how many shares they wish to sell them at the price they will take. The company involved in the share repurchase would then put together the right combinations so that it could purchase the shares it wants for the lowest price.
Companies can also enter the open markets to engage in stock buybacks. They do this precisely as individual investors by buying shares at the going market price. The difference between the company and an individual investor doing this is that the market sees a company repurchasing its own shares as a significantly positive action. This generally leads to the stock prices rising quickly.
A company management will state that the share repurchase is their best option for deploying the firm’s excess capital at that given point in time. The management of a firm is supposed to be interested in maximizing the returns for their stake holders. These stock buybacks do usually boost the value of shareholders. There are other motives for company managements buying back shares. They may believe that the stock market has overly discounted the prices of its stock shares.
Stock prices can decline from many different causes. These might be that earnings were less than anticipated, the economy is poor, or there are negative rumors surrounding the company. Firms that pay out millions of dollars to invest in their own shares show that the company management feels the market has punished their share prices unfairly with the discount. This is always seen positively.
Stock buybacks can also create better fundamentals for a company’s balance sheet. Since the repurchased shares become either cancelled or treasury stock, this lowers the number of outstanding shares as a result. This decreases the balance sheet assets as the cash is spent. With fewer assets on the balance sheet, the return on assets ROA goes up in the process. Return on equity ROE also grows as the outstanding equity is reduced. The markets generally prefer higher ROAs and ROEs. Managements that do share buybacks just to boost their balance sheet fundamentals are looked at negatively and as problematic.