How stocks are affected during a buyback

Q. What does it mean for a stock when the company buys back shares?
— Investor

A. When a company has a “stock buyback,” the company that issued the stock actually repurchases its own shares.

“Essentially, a buyback occurs when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously distributed among public and private investors,” said Alan Meckler, a certified financial planner with Cornerstone Financial Group in Succasunna.

Because companies raise capital through the sale of common and preferred shares, it may seem counter-intuitive that a business might choose to give that money back, Meckler said. However, he said, there are numerous reasons why it may be beneficial to a business to repurchase its shares, including ownership consolidation, undervaluation and boosting financial ratios.

Another major reason why businesses repurchase their own shares is to take advantage of undervaluation, Meckler said.

“Stock can be undervalued for a number of reasons — often due to investors’ inability to see past a business’ short-term performance,” Meckler said. “If a stock is dramatically undervalued, the issuing company can repurchase some of its shares at this reduced price and then re-issue them once the market has corrected, thereby increasing its capital without issuing any additional shares.”

Buying back stock can also be an easy way to make a business look more attractive to investors, Meckler said. By reducing the number of outstanding shares, a company’s earnings per share ratio is automatically increased, he said.

Additionally, short term investors often look to make quick money by investing in a company right before a scheduled buyback.

“The rapid influx of investors artificially inflates the stock’s valuation and boosts the company’s price-to-earnings ratio,” he said.

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Karin Price Mueller writes the Bamboozled column for The Star-Ledger and she’s the founder of NJMoneyHelp.com. Click here to sign up for the NJMoneyHelp.com weekly e-newsletter. Like NJMoneyHelp.com on Facebook and follow it on Twitter.