Companies frequently buy back shares of their own stock, often when they believe that the shares are undervalued. Done right, a stock buyback can boost the value of a company's shares and protect it against a hostile takeover. Done wrong, a buyback can be a waste of money – and may even send a "sell" signal to the investors you hope will want to buy.
While buying back your own stock could, in theory, improve your price per share, it can also take funds out of circulation that your business could have deployed in other meaningful ways.
Boosting Share Value
It's simple supply and demand: If the amount of your company's available stock exceeds the demand for those shares, the share price will fall. That costs your shareholders money, because their portfolios lose value. Buying back your own stock reduces the number of shares outstanding, which in theory, will boost the price per share, keeping current investors happy and perhaps attracting new ones. Buybacks also boost your company's earnings per share, a key indicator of a business' financial health.
The Advantage of Reducing Vulnerability
Buying back your own stock can reduce your vulnerability to a hostile takeover. An individual or enterprise hoping to take over your company might try to do so by buying up enough shares to acquire a controlling stake. Buying back shares and putting them under the company's control not only reduces the number of available shares but also raises the price of the ones the takeover artist is going after. This might be enough to foil the attempt.
The Disadvantage of Lost Opportunity
Money spent to buy back stock is money that can't be spent on anything else. Rather than investing $10 million in, say, new equipment that will benefit your company in the long term, you use that money in a bid to boost the share price. Neither strategy is guaranteed of success, of course, but if the equipment turns out to be a poor use of money, you can at least sell it. If the stock buyback fails to raise the share price, that money is gone. Further, buybacks may signal to investors that your company doesn't have any worthwhile uses for its money – a bad sign for future growth that could lead them to dump their shares, pushing down the very stock price you're trying to raise.
Buying High, Selling Low
The financial news and analysis website The Motley Fool warns investors to look at the circumstances surrounding a buyback. Sometimes companies are eager to buy back stock when they're doing well and their stock prices are elevated, then are forced to cut back on buybacks or even sell stock when they're not doing as well. Buying high-priced stock to sell at a lower price later on isn't a great deal for their shareholders.
Many companies reward their employees with stock or stock options. To keep that stock from diluting the value of the shares already on the market, the company buys back an equal number of shares. If your company is buying back stock for that reason, it may not be paying attention to the price. Indeed, if your employees are exercising their stock options, the share price is probably pretty high.
If times later get tight and your company needs to re-issue the bought-back shares to raise money, it will probably do so at a lower price. Buying high and selling low is the exact opposite of a smart investment.
Cam Merritt is a writer and editor specializing in business, personal finance and home design. He has contributed to USA Today, The Des Moines Register and Better Homes and Gardens"publications. Merritt has a journalism degree from Drake University and is pursuing an MBA from the University of Iowa.