When and why should a company buy back shares?

Under normal conditions, companies are listed on the stock exchange through an IPO, an initial public offering. With an IPO they sell a part of the company on the market by selling a certain number of shares. Over time, however, the company may decide to buy back shares held by investors to increase its own share.

A share buyback is a fairly common procedure in finance, and it has an impact on shareholders as it can influence the price of shares. For this reason, it is important to know what share buyback is, how it works and why listed companies resort to this practice in certain circumstances.

The meaning of buyback is the repurchase by its previous owner of an asset that now belongs to a third party. In finance, this refers to the buyback of shares, an activity that many listed companies resort to for various reasons.

For instance, a company might buy back its shares on the market to reward employees and managers who have achieved certain goals, or to acquire another company that will be paid for in company shares rather than cash.

A share buyback is often used to control the share price in an attempt to limit the effects of events that are external and internal to a listed company. If the stock is very low-priced and undervalued, the company can buy a lot of shares on the market and reduce the number of shares available to investors, causing the share price to rise by reducing supply while demand remains the same.

Another reason for buyback is a company's desire to increase its controlling share, for example to protect itself against hostile actions by a potential buyer.

When a company lists itself on the stock exchange, it issues shares - small parts of the company that entitle you to a share in its profits and in some cases also grant you the right to vote at shareholders' meetings. For example, if you own 100 Apple shares and the company pays a dividend of £0.25 per share, you can receive £25 just for owning shares in the company.

In return, companies can obtain useful capital for business growth to be invested in purchasing machinery, hiring more employees and opening new locations. However, in some circumstances this capital can only be used partially or not at all. This may be because of a lack of market opportunities for the company to grow, or because it is already large with an established position or has so much liquidity that its management has become a costly problem.

When a company pays a dividend to shareholders, it is essential that it uses its capital profitably, otherwise the cost of capital may become a considerable expense to bear. To help manage this, the company may decide to buy back its shares, reducing the number of shares in the hands of shareholders and consequently the dividend amount to be paid.

So in a nutshell, share buyback means that a company invests in itself, an operation that can be carried out for a variety of reasons.

A share buyback can have a positive short-term effect for shareholders. Let’s imagine that a company has 100 shares and makes an annual profit of £100. Earnings per share are therefore £1, with a stock market price of £10. If the company buys back 10 shares this means that 90 shares remain in the market, so earnings per share rise to £1.11 and the share price to over £10.

In this case, the shareholders benefit from the company's buyback as both earnings per share and share value increase. The shareholders don’t have to do anything, and in the short term they are able to enjoy an increase in their investment.

However, a buyback transaction could hide problems with a company, which, for example, might not be able to increase earnings per share as its business grows. A buyback could also be financed with new debt, especially when banks provide resources with particularly low interest rates, a debt that risks weighing on a company's future balance sheet.

To understand whether a share buyback is a positive or negative transaction for shareholders, you must assess each on a case-by-case basis, analysing a company's motivation for the share buyback and the way in which it carried out the transaction.