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Why do corporations buy back their own stock? What does it

Resolved Question:

Why do corporations buy back their own stock? What does it tell you about the corporation? What affect does the purchase have on the price of a company’s stock? If so, is this ethical? Explain why.
Submitted: 4 years ago.
Category: Tax
Expert:  Dave CPA replied 4 years ago.

When a company buys back stock this is referred to as Treasury Stock.

Treasury stock can be created when a company does a share buyback and purchases its shares on the open market. This can be advantageous to shareholders because it lowers the number of shares outstanding. However, not all buybacks are a good thing. For example, if a company merely buys stock to improve financial ratios such as EPS or P/E, then the buyback is detrimental to the shareholders, and it is done without the shareholders' best interests in mind.

A company buying back its stock should have no effect at all on its stock price. If the market fairly prices a company's shares at $50/share, and the company buys back 100 shares for $5,000, it now has $5,000 less cash but there are 100 fewer shares outstanding; the net effect should be that the value per share is unchanged. However, buying back shares does improve certain per share ratios, such as price/earnings, but since the market risk increases by the same amount, the share value remains unchanged.

If the market is not efficient, the company's shares may be underpriced. In that case a company can benefit its other shareholders by buying back shares. If a company's shares are overpriced, then a company is actually hurting its remaining shareholders by buying back stock.

One other reason for a company to buy back its own stock is to reward holders of stock options. Call option holders are hurt by dividend payments, since, typically, they are not eligible to receive them. A share buyback program may increase the value of remaining shares (if the buyback is executed when shares are underpriced); if so, call option holders benefit. A dividend payment short term always decreases the value of shares after the payment, so, for stocks with regularly scheduled dividends, on the day shares go ex-dividend, call option holders always lose whereas put option holders benefit. This does not apply to unscheduled (special) dividends since the strike prices of options are typically adjusted to reflect the amount of the special dividend.

A company that buys back it's own stock is a common practice and wouldn't be considered unethical. If it were deemed unethical then many companies wouldn't do it. It's a normal transaction in the normal course of business.

I hope this helps.
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