Stock Buybacks: Hidden Risks & Potential Drawbacks for Investors

A stock buyback occurs when a company decides to purchase a large number of shares of its own stock from the market place. While investors typically look at this scenario as a good thing, there are definitely a few drawbacks to a stock buyback. Here are a few of the potential downsides of a stock buyback.

Lose Appreciation

When you choose to be involved in a stock buyback, you are going to essentially be selling your shares back to the company. If you agree to sell your shares, you will no longer be able to benefit from the appreciation of the stock price. Many times, when it becomes evident that a stock buyback is occurring, the price of the stock is going to escalate. If you sell your shares to quickly, you may not benefit from the full market movement of the stock.

Improve Ratios

Many times, a company will claim that investing in their own company is the smartest financial decision that they could make. In many cases, it is not as simple as this. Instead, they may be trying to improve the financial ratios of the company. Financial ratios are one of the most common tools that investors and analysts use to measure the financial health of a company. These ratios are used to decide whether an investor should invest in a company or not. If these ratios can be improved, a company might be motivated to take the necessary measures to do so. By implementing a stock buyback program, they are going to be able to lower the amount of cash that they have on hand and the amount of outstanding shares that are in the market place. When they do this, they are going to be able to improve the return on assets because they reduced the amount of assets while keeping the returns the same. The company can also improve the price/earnings ratio because they are lowering the amount of shares that are available and potentially increasing the price of the stock in the market.

Combat Dilution

Many large corporations use employee stock options to retain the best talent in the industry. One of the drawbacks of this type of program is that it creates additional shares of stock in the market place. This has the tendency to dilute the value of the price of the stock in the market. When a company has a stock option program, they may need to do a buyback just so that they can make up for diluting the market in the first place.

Increased Stock Price

Companies will sometimes pursue a stock buyback just so they can manipulate the price of the stock in the market. When a company believes that their stock price is too low, they may buy some shares of the stock so that they can please their existing shareholders. This is not actually improving anything about the business, but it is attempting to control the market.