A share buyback, or share repurchase, is a corporate exercise that a company undertakes to repurchase or reacquire its own shares. You may have heard of it, or the companies that you invest in may have done so before. However, many investors do not fully comprehend the implications of share buybacks to the shareholders’ value. By the end of this article, you as an investor will be able to identify:
- the common reasons for companies to buy back their shares;
- the effect of share buybacks on share prices; and
- how share buybacks benefit the shareholders.
Why do companies buy back their own shares?
When a company repurchases its own shares, it is basically investing in itself and simultaneously reducing the number of outstanding shares in the market. By reducing the number of shares outstanding on the market, buybacks increase the proportion of shares a company owns. When this happens, it means that the existing shareholders’ stake in the company will increase. Therefore, share prices usually respond positively to share buybacks.
Share buyback is very common
One of the most common reasons for companies to announce a share buyback programme is when management considers that the share price of the company is undervalued on the open market. However, the drop in a company’s share prices is usually temporary and could be due to lower-than-expected earnings, or cyclical effects, that will be corrected over a short period of time. If, in evaluating the option of a share buyback, the management finds that it is a better way of spending the company’s capital and will bring higher value to the shareholders compared to their investment projects, a share repurchase programme will be initiated.
Undervalued or overvalued?
How exactly does this action benefit the shareholders? The company can take advantage of the temporarily depressed share price and increase its profits by repurchasing its own shares in the open market when the share price is undervalued, and reissuing the shares when the share prices increase. Alternatively, the company may also tender an offer — usually at a premium above the current market rate — to purchase the company’s shares from existing shareholders. This will directly benefit shareholders who are willing to sell their shares back to the company. Reacquisition of shares in this manner sends a positive signal to the market that the company has high confidence in its shares. Subsequently, this pushes the market price of the company’s shares up.
Current and past dividend payout
A company also initiates a share buyback programme with the intention of distributing special ‘dividends’ to its shareholders. Companies prefer to maintain a stable dividend payout ratio to shareholders as shareholders usually base dividend expectations on past dividend payouts, and will react negatively if the dividend yield drops. Therefore, when a company has vast amounts of retained earnings after the usual dividend payouts and capital spending are accounted for, the excess cash will be used to repurchase its shares. By offering to buy back the company’s shares at a premium, the company is basically distributing ‘special’ dividends to shareholders who decide to take up the offer. Compared to increasing the dividend payout, share buybacks are a better option for companies that prefer to maintain a stable dividend yield as it is considered a one-time value distribution, and shareholders will usually not build into their dividend expectations.
Pay attention to company’s financial ratio
However, the management may sometimes initiate a share buyback programme simply because it will help to improve the company’s financial ratio. As top management’s performance indicators are often tied to a company’s financial ratios such as return on assets (ROA) and return on equities (ROE), using the company’s moneys — which is part of the asset component — to repurchase its own shares will reduce the amount of assets in the balance sheet. Hence, the number of outstanding shares is also reduced. This, in turn, brings down the equity of the company. Subsequently, even though a company’s earnings remain the same, having a lower number of assets and equities will mean that both ROA and ROE ratios will increase. The company’s earnings per share (EPS) will also improve.
Attracting investors in the stock
As the market usually bases a company’s performance on its EPS, the management may want to boost the EPS in order to make the company look more attractive to investors. However, this exercise does not create any real value to the shareholders. In fact, if the shares are being repurchased at a price that is above its intrinsic value, or if the earnings can be used to run other projects that will generate better returns to the company, this exercise will adversely impact the shareholders’ value.
Therefore, it is imperative for the shareholders to understand why share buyback programmes are undertaken by a company. It will help shareholders to gauge the quality and integrity of management within a company.