If you follow the financial news, you’ve probably heard of a stock buy-back program. If you don’t follow the news, you probably haven’t. But don’t worry, whether you’ve heard of it or not it’s an interesting topic ans we’re going to talk about it today.

A stock buy-back program is exactly what it sounds like. Companies issue stock to raise money for their business. Sometimes they’ll buy some of that stock back from shareholders. In more official channels buybacks are referred to as share repurchases. Companies do this all the time, CVS has been working on it, so has Autozone and Cablevision.

How does a buyback work? In essence, the company will have some cash and go into the open market and purchase shares just like anyone else. They usually purchase a large number of shares and so they do it over a period of a few weeks or months. Otherwise there will be a huge surge in prices as there are many more buyers than sellers. Sometimes they might buy it directly from a major shareholder, if they are interested in selling. However I suspect this is less common.

Why would a company buyback stock? So there’s a running theory in business, you got to spend money to make money. In other words, growing profits requires investment. That’s new people, new equipment, maybe buying a competing company, advertising, etc etc etc. So when a company wants to grow, but doesn’t have any money, they have to go and borrow it. This is a time when they have to get a loan or maybe issue new shares to raise new cash. So in essence, when a company says they’re going to repurchase shares, they’re literally saying they have more money than they know what to do with. In the business world, this isn’t really a good thing. It’s kind of like saying, “we’re out of ideas”. So an existing shareholder can be happy that their shares will be less diluted (and thus worth more). But they can also ask “where is the future growth going to come from?”

But not always. There are other reasons a company might buy back shares. For example, let’s say a company has an ideal ratio of debt to equity of 30% debt and 70% equity. This kind of leverage isn’t much different than from you borrowing money to buy a home. But what if the value of the equity has increased because they raised money issuing new shares. They might simply borrow money (by selling corporate bonds) and use the cash from that sales to buy back shares. Personal finance mavens might gawk at such a move, but it’s actually cheaper to borrow money than it is to have shareholders. The effective interest rate on a bond might be 7%, but on a stock it could be twice that.

They could also want to buy back shares because they think their stock price is cheap. Who is going to know better than them what their company is worth? By purchasing shares back when it’s cheap, they can reissue those shares at a later date without further diluting the company.

Do share repurchases matter to people that buy index funds and ignore regular financial news? No, but I think you like reading about this stuff anyway.

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categories: business, investing, personal finance