Decoding Share Buybacks: How Do They Work?

When a company repurchases its own shares it's called a share (or stock) buyback. Companies have two options when they want to buy back shares:

1. Most commonly, a company will repurchase its shares in the open market, just like how you as an investor would buy shares. In Canada, a buyback in the open market is known as a normal course issuer bid.

2. A company can also make what's known as a "tender offer" to its existing shareholders, which allows interested shareholders to sell or "tender" their shares directly to the company.

Buying back shares is one way a company can return cash to its shareholders. (Dividends are another.) Once shares are repurchased, a company can cancel those shares, which reduces the number of shares it has outstanding.

Why do companies repurchase their shares?

Companies buy back their own shares for reasons such as:

Investment — If no other investment option for its cash looks as appealing as its own equity, a company may plan a buyback. This could be considered a more conservative, less-risky choice than using cash to acquire a competitor, for example. On the flip side, it could also indicate growth opportunities may be tough or expensive to pursue.

Shareholder Value — After the company repurchases shares it can choose to cancel them, thereby reducing the number of shares outstanding. If a company maintains its same level of profitability, earnings-per-share (EPS) would typically increase since the company's profits would be distributed among fewer shares. A rising EPS may also sometimes result in an increase in share price over time.

Ownership Considerations — Each share represents a partial ownership of a business and often, these shares come with voting rights on the company's financial decisions. By repurchasing its shares, the company can reduce the number of co-owners and consolidate ownership into fewer hands, which could make governance easier.

Flexibility — Companies return value to shareholders in three main ways: dividends, return of capital and share buybacks. Dividends represent a commitment to pay a fixed amount on a regular basis to all shareholders of record. Should a company have to cut or eliminate a dividend payment, a selloff based on that news could drive down the share price. By opting for a share buyback instead of a dividend, companies can return some cash to shareholders without committing to a long-term dividend policy.

Keep in Mind

Mixed Signals — A buyback can send mixed signals to the market, meaning there's no real rule of thumb as to how shares will react. A buyback can be seen as a vote of confidence by management because, among other things, it can demonstrate the company is financially healthy and doesn't need additional equity financing. However, a buyback could also be interpreted as a poor deployment of cash by management. If a company takes on debt to repurchase its shares, it could lead to a lower credit rating, which may make it costlier to run the business. It may also signal few growth opportunities are available as an alternative to deploying excess cash.