Student Finance Guide: All About Stock Buybacks

Corporations have many ways of creating wealth for shareholders. They can grow the business --and increase earnings -- through operations, they can make profit and pay dividends, or they can take that profit and buy back its shares. When companies buy back their shares they increase their shareholders' piece of the pie.

Think of a stock buyback like this: You and your friends go to the pizza parlor and purchase one pitcher of beer for $10. The beer is poured into four glasses. Now you have four beers worth $2.50 each. One of your friends decides he doesn't want a beer and pours it evenly between the other three friends. The total beer amount is the same, but the three remaining beer owners have a larger 'worth' of the pitcher.

A stock buyback increases the percent of the total company each shareholder owns, but the worth is not always increased, a company can overpay for the shares.

Corporations usually repurchase the shares on the open market, and all too often, management overpays. Sometimes a company has fundamental problems and the stock goes into free fall. Those running the company can authorize a buyback to keep the stock pumped up. This benefits those selling at the time of the buyback, but long term investors can be hurt. Famous investor Warren Buffet describes the situation in such a way:(repurchases) are often made to pump up ...the stock price, but the shareholder is penalized by repurchases above value. Buying dollar bills for $1.10 isn't good business for those who intend to stick around.

A good stock buyback is one that will increase the company's long term value. Good corporations look for ways to grow the worth of the company. This can be by reinvesting into new equipment, expanding to markets, paying dividends to shareholders, or repurchasing stock. A well calculated buyback is one that is a bargain for the company, and therefore a deal to the shareholders.

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