Why A Company Would Buy Back Its Own Shares
Since companies raise equity capital through the sale of common and preferred shares, it may seem counter-intuitive that a business might choose to give that money back. However, there are numerous reasons why it may be beneficial to a company to repurchase its shares, including ownership consolidation, undervaluation, and boosting financial ratios.
The Stock Is Undervalued
A major reason why businesses repurchase their own shares is to take advantage of undervaluation. Stock can be undervalued for a number of reasons, often due to investors' inability to see past a business' short-term performance or sensationalist news items.
If a stock is dramatically undervalued, the issuing company can repurchase some of its shares at this reduced price and then re-issue them once the market has corrected, thereby increasing its equity capital without issuing any additional shares.
For example, let's assume a company issues 100,000 shares at $25 per share, raising $2.5 million in equity. An ill-timed news item questioning the company's leadership ethics causes panicked shareholders begin to sell, driving the price down to $15 per share.
The company decides to repurchase 50,000 shares at $15 per share for a total outlay of $750,000 and wait out the frenzy. The business remains profitable and launches a new and exciting product line the following quarter, driving the price up past the issuing price to $35 per share.
After regaining its popularity, the company reissues the 50,000 shares at the new market price for a total capital influx of $1.75 million. Because of the brief undervaluation of its stock, the company was able to turn $2.5 million in equity into $3.5 million without further diluting ownership by issuing additional shares.
Improve Financial Ratios & Boost Investor Confidence
If a company is buying back shares, it can also be viewed by the market that management has enough confidence in the company to reinvest in itself. Investors typically see share buybacks as a positive sign that growth is likely to increase in the future. As a result, share buybacks can lead to a rush of investors buying the stock.
