There are a number of ways in which a company can return wealth to its shareholders. Although stock price appreciation and dividends are the two most common ways of doing this, there is also something called shareholder buybacks.
Buybacks are a less direct way of returning cash to shareholders, explains Hardeep Walia, founder and CEO of Motif Investing.
Under a share buyback, a company purchases a certain number of its own shares. It may do this on the open market, like everyone else, or by making a tender offer to shareholders, usually at a slight premium to the market price, explains Walia.
The company then cancels the purchased shares, reducing the total number outstanding, making each remaining share worth that much more, he says.
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The question for investors is: Which form of payback is better? Dividends are tough to beat, Walia contends, because they put cash in your pocket and give you the flexibility to decide what to do with it.
But there are also plenty of reasons to like buybacks. According to Walia, these are some of the pros and cons to buybacks that shareholders should consider.
There are greater earnings per share with buybacks. Assuming the company doesn't do anything to interfere with its current progress, the earnings per share would usually increase. Additionally, contrary to dividends, a buyback leads to an increase in shareholder value without the tax burden. So a company having a good year could use this as a way to indirectly pay their investors.
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But at the same time, this same money used to buy back shares could have been put to good use internally to invest in innovation for long-term growth—for research, product development, expansion into new markets and marketing, Walia explains.
So overall, for a short-term investor a buyback is almost always a bonus. For the long-term investor, however, these share-buyback programs are a great cause for concern.