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Does a Stock Buyback Affect the Price?

Original post by Slav Fedorov of Demand Media

A stock buyback usually pushes up the price, but how much it does depends on multiple factors such as the buyback's size, timeframe and execution, the reason for the buyback and the stock's prior price trend.

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Stock Valuation

A stock buyback reduces the number of shares outstanding (issued and in the hands of investors). Since stocks are valued on a per share basis, a buyback makes them more valuable, or cheaper, and thus more attractive to investors. For example: If a company earned 1 billion dollars and has 1 billion shares outstanding, its earnings per share (EPS) are $1. If the company then buys back 100 million shares, its EPS jump to $1.10. The stock has become more valuable because a share now buys 10 percent more in earnings, or is cheaper because its price-to-earnings (P/E) -- current stock price divided by the EPS per share -- has gone down, so investors are likely to pay more for it.

Size of Buyback

The more shares a company buys back relative to the total number of shares outstanding, the greater a buyback's impact on a stock price can be. For example: A company's buyback of 10 percent of its outstanding stock would have a greater impact on the stock price than a one percent buyback.

Timeframe and Execution

A buyback increases the number and often the size of buy orders. The shorter a buyback's timeframe, the stronger its impact, because increased buying is likely to push up the stock price. How a buyback is executed can also make a difference. For example: Large buy orders "at the market" would have a stronger impact on a stock price than a standing buy order at a specified (limit) price.

Reason for Buyback

The main reason for a stock buyback is to enhance shareholder value -- push up the stock price. A company must have cash for a buyback, but cash can be spent in a variety of ways: in addition to a stock buyback, it can be reinvested in the business to facilitate growth, or used to make an acquisition or pay dividends. Investors feel enthusiastic about a stock buyback when they think it is the best way to enhance shareholder value.

Prior Stock Trend

A stock buyback makes the most sense when shares are undervalued. A company may be wasting money buying back its stock if it appears expensive. Poor market conditions can push a good stock down, below any reasonable valuation. A buyback can reverse such a downtrend, or at least check further decline.


                   

References

  • "PassTrak Series 7: General Securities Representative License Exam"; Dearborn Financial Services; 2003
  • "How to Make Money in Stocks"; William O'Neil; 2009

About the Author

Based in San Diego, Slav Fedorov started writing for online publications in 2007, specializing in stock trading. He has worked in financial services for more than 20 years, serving as a banker, financial planner and stockbroker. Now working as a professional trader, Fedorov is also the founder of a stock-picking company.


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