DCF Hardo Tech Practice Test

A share buyback, also known as a stock repurchase, can influence the Price-to-Earnings (P/E) ratio primarily due to its impact on the number of shares outstanding and the overall earnings per share (EPS). When a company repurchases its own shares, it reduces the total number of shares in circulation. Since the company's earnings remain the same, dividing those earnings by a smaller number of shares results in a higher EPS.

The P/E ratio is calculated by taking the current share price and dividing it by the earnings per share. If the share buyback leads to an increase in EPS, the numerator (the price) does not necessarily change immediately, which can cause the P/E ratio to reflect this shift. However, the assertion that the P/E ratio decreases because equity value reduces highlights how market perceptions and conditions can shift.

It’s crucial to remember that the reduction in equity, stemming from funds used for the buyback, can signal to the market a potential undervaluation of the stock or can imply that a firm believes its shares are undervalued. This market perception can lead to a decrease in the overall stock price, potentially adjusting the P/E ratio downwards.

Therefore, through the mechanics of share buybacks affecting both