Stock buybacks have been in the news as of late as they reach all-time highs and are set to top $1.1 billion in 2025 (see recent Wall Street Journal article here). This prompted a client to ask what they are and why they matter to markets

Stock buybacks are essentially defined by their name. It’s the practice of a company using cash to repurchase (ie: buyback) some of their outstanding shares (ie: stock). To fully understand buybacks, it’s important to revisit why companies issue stock in the first place.

Companies have a few options to fund their businesses (both at inception and during their lifecycle). They can self-fund (ie: use the cash the business generates to pay expenses and fund their growth) or they can raise outside capital either via debt (borrow cash with the promise to repay + interest) or stock (also known as equity). When raising capital via stock, companies take cash from investors in exchange for shares of stock. These shares entitle the investor to their pro-rata portion of the future earnings and cash flows of the business for as long as the shares remain outstanding.

As a company continues on in its lifecycle, it will generate free cash flow from operations. With that cash, the business will pay its expenses, invest in future growth (ex: research & development), and will then have cash left over. With that cash, the business has a few options. They can retain those earnings for future years, distribute cash to shareholders (in the form of a dividend), or use the cash for some other use such as a share buyback. Why would a company take its hard earned cash and buy its own shares?

By repurchasing their own shares, a company gains a few advantages. One, they now have to distribute a lower amount of earnings in the future as there are less shares outstanding. Two, a lower number of outstanding shares makes per share metrics (such as earnings per share) stronger as the denominator is now lower. Three, since stock prices are ultimately a supply and demand function, by reducing the supply of shares on the market, the price can appreciate if buybacks are large enough relative to the total share pool. Lastly, share buybacks can be a signal of confidence from management to investors that they believe their share price to be fairly (or under) valued, thereby boosting perception as well.

Share buybacks can also be used for more technical reasons, such as funding stock compensation or preventing hostile takeovers – but more often than not, its a means of “corporate engineering” for the reasons noted above.

Share buybacks do get their fair share of criticism as many argue there are better uses for company funds and that they are used to manipulate per share results and share prices. However, the importance of these transactions to equity markets and the underlying support of equity prices should not be overlooked by any investor.