Eli5: why do stock buy-backs benefit corporations?


Eli5: why do stock buy-backs benefit corporations?

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Selling shares in your company brings in cash to help grow the company (or enrich the owners) but now you’re answerable to whomever bought those shares. You’ve seen how disruptive that can be with Elon Musk owning less than 10% of Twitter causing a huge upheaval and trying to get other investors to sell their shares to him for a takeover.

Stock buy-backs put the company back fully under control of a much smaller group of people, and profits don’t have to be split with shareholders.

You have a company with 100 shares outstanding and report earnings of $100, or $1/share.

You buy back 10 shares, now only have 90 shares outstanding. Next quarter, you again report earnings of $100, but now that’s $1.11/share. Assuming that your PE remains constant, the share price should rise accordingly, creating more shareholder value for those remaining shareholders.

it increase earnings per share (because fewer shares), which can in turn can increase stock price.

it reduces the number of shareholders or their power, meaning that the board has fewer people telling it what to do. Buying out all/most of the stock means making company private, partial buyback is a step towards that.

there are a few other reasons:

A stock buyback is when a company uses cash to buy its own shares from the open market.

Shares are sold to build capital to help grow and maintain a company, buy buying them back the company is in a sense returning that money to shareholders.

Companies don’t like keep large amounts of cash on hand because that’s money that isn’t helping the company. So a stock buyback is one way to funnel that cash into the pockets of the shareholders.

Having less shares on the market also helps keep the share price stable, and can increase the share’s value. Less shares also can mean that dividend payments get better.

Having less stocks also means you consolidate more power into the remaining share holders. Since owning stock gives you a say in the management of the company, having less stocks in the market means that the major stock holders have more power.

So why are stock buybacks controversial?

Several large corporations have taken bailouts from governments during bad economic times in order to keep the company afloat. They then used some of that money to perform stock buy backs rather than keeping the company afloat. So public money has been used to directly enrich shareholders instead of helping out employees.

Say 5 people start a business — you and 4 friends. You each pay $100, and you’re all equal partners owning 20% (or 1/5) of the company. The $500 goes into the company’s bank account.

Now let’s calculate how much your shares are worth. You own 20% of a company worth $500, your shares are worth $100. Easy.

If the company does a buyback, and buys Bob’s shares for $90, the bank account now has $410 and the remaining 4 people have 25% of the company.

Now let’s calculate again how much your shares are worth. You own 25% of a company worth $410, your shares are worth $102.50.

Look at it like this: In the beginning everybody paid $100 to get in as an investor. The company paid Bob $90 to get out. Bob lost $10 by selling his shares for $10 less than he paid for them. The company gained $10, and it’s split 4 ways among the stock value of the company’s remaining owners. The company underpaid relative to what the shares were worth, and made money from Bob.

This can happen in reverse: If the company buys Bob’s shares for $110, everybody else’s shares are worth 1/4 of $390, or $97.50. The company overpaid relative to what the shares were worth, and lost money to Bob.

“What the shares are worth” is easy to calculate in our examples because our simple example company didn’t actually do any business, it was just some money sitting in a bank account. A real-world business has sales / income / loans / employees / long-term contracts / stuff like branding or technology. It can be a lot harder to put numerical value on what the company’s worth, which makes it more difficult to decide whether a buyback makes sense numerically.