Rolls-Royce will return £1bn to shareholders instead of buying another company to restore investor confidence in the firm.
The company's shares climbed 7.4 per cent to 1,085 pence, their highest in more than two months, after it made the announcement today. The stock had lost 17 per cent of its value over the past six months.
Until the start of this year, Rolls-Royce had enjoyed 11-years of strong profit and revenue growth as soaring demand for more fuel-efficient engines for passenger planes made by Airbus and Boeing boosted its civil aerospace unit, which generates about half of its sales.
But investors' confidence was shaken by a failed attempt to acquire Finnish ship and power plant engine maker Wartsila in January, followed by a profits warning the month after and then finally a an engine order cancellation from Airbus last month.
"The buyback is good news because it shows the company is committing itself to very tight capital discipline, prioritising rewarding shareholders ahead of expanding the footprint. This is exactly the message we were looking for after a challenging six months," said Espirito Santo analyst Edward Stacey.
Rolls-Royce upset investors in January when it revealed it had made an €8bn (£6.4bn) takeover approach to Wartsila, which although unsuccessful, left some investors wondering whether the company was spending indiscriminately in the pursuit of growth.
Rolls-Royce was interested in Wartsila as a way to strengthen its Marine engine business, where it has cut profit forecasts twice in a year.
The share buyback, the company's first since it was privatised in 1987, "shows they get how much the Wartsila story frightened investors", said Edison analyst Sash Tusa.
It is equivalent to about 5 per cent of Rolls-Royce's £19bn market capitalisation, and will be funded partly by proceeds from the £785m disposal of its gas turbine unit to German conglomerate Siemens AG, agreed in May.
Speaking to investors today, Rolls-Royce Chief Executive John Rishton conceded that the company needed to communicate better with them and that starting in October, the firm plans to switch to issuing its outlooks in percentage and number terms, instead of its historic references to "good" or "modest" growth, he said.
Rolls-Royce also said it would reduce group capital expenditure to 4 per cent of underlying revenue over the next three to five years from 4.9 per cent at the end of 2013.
The company reiterated that it was on track for flat earnings this year and to return to growth in 2015, when it is due to ramp up aero engine production.
"I'm confident that we have sustainable growth, but that does not mean year-after-year consistent growth, it means long term sustainable growth," Rishton said.