Publicly held corporations face the ongoing challenge of managing their stock's price and the EPS, or earnings per share, they produce. One of the methods employed to accomplish this, a share buyback, helps firms offset internal events that dilute the company's EPS and affect its shareholders' equity. The strategy may also help counteract the effects of negative market perceptions of the company's value.
Shareholders' equity, also called stockholders' equity, is one of the three components of a company's balance sheet. The other two categories are assets and liabilities, and stockholders' equity represents the difference between the assets and liabilities. The shareholders' equity section of the balance sheet reflects the account balances of common and preferred shares outstanding, paid-in capital, retained earnings, treasury stock and other accounts, depending on the nature of an individual firm's transactions.
The balance of shareholders' equity fluctuates with changes in retained earnings and the company's buying and selling of its own stock. Companies sometimes decide that the market is undervaluing their stock. In this case, the company buys back some of its shares, reducing the amount of available shares in the market. In some cases, this increases the price of the remaining shares. Companies also repurchase their shares to offset diluted EPS, or earnings per share, due to employee stock option grants. From an accounting perspective, shareholders' equity decreases with a share buyback, because the company must use up its cash assets or take on debt to repurchase shares.
After a share buyback, the company records the shares on its balance sheet as treasury stock. Fewer shares outstanding immediately increases the company's EPS. However, investors are aware of the cost of buying shares back, which may increase the company's risk of not having enough cash available to cover its debt and other obligations. If the share repurchase was the right decision for the company, individual shareholders stand to see the equity value of their shares increase.
Investors should evaluate whether a company is putting its excess cash to work in the right ways when analyzing a share buyback. Paying higher dividends does not reward investors as much as a share buyback in terms of creating more value. Conversely, company management might attempt to boost a company's share price through stock buybacks to hide the fact that the company's growth is reaching a plateau. Additionally, the higher a company's price-earnings ratio, the less effect a share buyback will have on the stock price.