Share Buybacks
Share repurchases are a way that a company returns cash to its shareholders by buying back its own shares.
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What Is A Share Repurchase or Buyback?
Companies buy back shares of stock to reduce the number of shares outstanding so that each share represents a higher percentage of future company earnings.
Once bought back, shares are either canceled, thus reducing the number of outstanding shares, or they are held by the company as treasury shares. Treasury shares are a portion of shares that a company keeps in its treasury that have been repurchased or never issued at all. Treasury shares have no voting rights nor do they pay out any distributions. These shares can be issued to the public in the event that a company needs to raise capital.
In a statement, public companies typically announce that the board of directors has passed a "repurchase authorization", and the statement contains one of the following:
- The total amount of money allocated to buy back shares.
- The number of shares it intends to buy back.
- The percentage of outstanding shares that it will buy back.
Why Companies Buy Back Their Shares
When a company finds itself with more cash than it needs for its everyday operations or future expansion, it can return some of that excess cash to its shareholders in either of two ways:
- Dividends: periodic cash payments to shareholders.
- Share buyback: a company buys shares of its stock on the open market or through shareholders tendering their shares at a specific price.
There are several reasons why a company may choose to buy back some of its own shares.
1. The Stock is Undervalued
A company's board of directors may decide that the company's stock is undervalued due to a bearish market, bad news about the company in the press, or recent poor performance. By buying when the share price is low and holding onto the shares, a company can sell those shares once the economy improves or its share price rises.
Let's look at an example of how this might work:
- The Marx Widget Company issues 1,000,000 shares at $40 per share, thus raising $40,000,000 in equity.
- There is a sudden downturn in the widget market and Marx's share price drops to $30 a share.
- The Marx Widget Company repurchases 166,666 shares at $30 per share, paying $5,000,000; Marx's total equity now stands at $35,000,000 ($40,000,000 - $5,000,000) with 833,334 shares outstanding. Each shareholder now holds a higher claim on the future profits of Marx.
- People discover how wonderful widgets are and Marx's share price rises to $50 per share.
- The company reissues the 166,666 shares that it bought back at the new market price of $50 per share, reaping $8,333,300; its total equity now stands at $35,000,000 + $8,333,300 = $43,333,300.
- Through its buyback, the company was able to increase its equity by $3,333,300 without further diluting ownership.
2. To Make a Company More Attractive
When the number of outstanding shares is reduced, a company's
earnings per share ((EPS)) ratio increases because:EPS = Net profit/number of outstanding shares of common stock
For example:
- The Marx Widget Company has 1 million outstanding shares and a net profit of $10 million a year, $10,000,000/1,000,000 = $10, so Marx has an EPS of $10.
- Suppose the company then buys back 100,000 of those shares, reducing its total outstanding shares to 900,000.
- Its EPS would then be $10,000,000/900,000 = $11.11, without there being any actual increase in earnings.
Types Of Share Repurchase Programs
1. Open Market
A company buys back its shares from the market at the current market price and it doesn't need to pay a premium. Transactions are executed by the company's brokers, and buying back a large number of shares typically takes a long period of time. With this method, the company is not legally obligated to complete the buybacks, and it can cancel the buyback program at any time. This method's primary advantage is its cost-effectiveness.
2. Fixed-Price Tender Offer
A company makes a tender offer to its shareholders to buy back their shares on a certain date at a certain price. This price usually includes a premium, meaning that it is greater than the current market share price. Shareholders who want to sell some or all of their shares submit the number of shares they are willing to sell to the company. The advantage of a tender offer is that it allows a share buyback to complete within a short period of time.
3. Direct Negotiation
A company approaches several large shareholders and offers to buy back shares from them. The company negotiates a buyback price with the shareholders, and in most cases, that price includes a premium. The main advantage of the direct negotiation method is that it can be highly cost-effective, but only under certain circumstances.
4. Dutch Auction Tender Offer
In a Dutch auction tender offer, a company offers to buy back shares from shareholders but it doesn't provide a specific price. Rather, it provides a range of prices with a minimum and a maximum and the minimum is usually above the current market price. Shareholders respond with the number of shares they are willing to sell and the minimum price they will accept. The company reviews those bids and determines a price from within the previously specified range.
The main advantages of a Dutch auction tender offer are that the company is able to set a share price based on the feedback of its shareholders, and the buyback can be completed quickly.
Pros & Cons Of Share Buybacks
Pros of Share Repurchase Programs
- Returns more to shareholders: without locking itself into a dividend, a share repurchase allows a company to return more money to shareholders. A company can combine a share repurchase program with the issuing of dividends. For example, if the Marx Widget Company wants to return 50% of its earnings to its shareholders, it could pay out 25% of those earnings in the form of dividends, and the other 25% in the form of share repurchases.
- Keeps investors happy: investors want distributions whether in the form of a dividend or a buyback.
- Tax implications: large shareholders may not want the increased taxes that are caused by dividends, while a share-repurchase program doesn't have immediate tax implications because there's no payment to shareholders. However, in October 2021, the "Build Back Better" program announced by the White House proposes a 1% tax on buybacks, stating that "corporate executives too often use [buybacks] to enrich themselves rather than investing [in] workers and growing their businesses." Also, in countries where the money shareholders receive from a stock buyback is treated as capital gains, the capital gain tax rate is sometimes lower than the dividend tax rate.
- Offset dilution: many growing companies and high-tech companies seek to attract or keep talented employees by issuing stock options. When those options are exercised, the total number of shares outstanding increases thus diluting the value in the hands of existing shareholders because each shareholder now owns a smaller percentage of the company. Share buybacks allow companies to offset this effect.
Hostile takeover defense: management of a target company can buy back some of its shares to diminish the chances of a suitor obtaining a controlling interest. Companies also can institute a "poison pill" defense that allows existing shareholders the right to purchase additional shares at a discount, thus effectively diluting the ownership interest of the hostile party.
Cons of Share Repurchase Programs
- Falling share prices: companies have the cash to implement share repurchases when the stock market is doing well and they are financially healthy. It is at just those times that the share price is likely to be high and, if after the repurchase either the market drops or the share price drops, it could have a negative effect on the company.
- Downgraded credit rating: if a company has to borrow money to finance its stock repurchase, called a leveraged buyback, it will adversely affect the company's credit rating. Having its credit rating downgraded means the company will have to pay a higher rate of interest to borrow money from a bank or to investors if it issues a bond.
- Limited growth potential: a share repurchase can imply to investors that a company doesn't see many opportunities for growth, or that is not investing in research and development.
- Mask falling income: by reducing the number of outstanding shares, a share repurchase can mask a fall in net income because the EPS will rise despite the fall in net income.
- Conceal stock-based compensation: many public companies reward their executives in the form of stock, and this dilutes the stock held by other shareholders. Companies may use buybacks to hide this form of compensation.
Impact To Business Valuation Of Share Repurchases
A share buyback reduces both a company's total number of shares outstanding and the total amount of cash on its balance sheet. If a company's total earnings stay the same but the number of shares outstanding falls, the company's earnings per share rises. If a company's stock price stays the same but its earnings per share rises, then the company's price-to-earnings ratio will fall.
When the amount of cash on a company's balance sheet is reduced by a buyback, the company's
return on assets (ROA) will increase.ROA = Net income/Average assets
For example, if the Marx Widget Company posts net income of $10 million and it owns $100 million worth of assets, its ROA is $10 million/$100 million = 0.1 or 10%. That means that for every dollar of assets, the company returns 20 cents in net profit per year.
Return on equity (ROE) will also rise because a buyback reduces outstanding equity. ROE is calculated by dividing net income by shareholders' equity, which is equal to a company's assets minus its debt. ROE is considered the return on net assets.Impact On Investors Of Share Repurchases
By reducing the number of outstanding shares, each remaining share becomes worth more, however, the main benefit to shareholders of buybacks is that they improve the metrics that we described above which are used to value a company.
Bottom Line
For investors, a stock buyback can be a positive thing if a company is doing well and has the cash to implement the buyback. However, if the company initiates a buyback to raise its share price while ignoring its future growth potential then shareholders will lose value in the long run.
This article was written by
Analyst’s Disclosure: I/we have no stock, option or similar derivative position in any of the companies mentioned, and no plans to initiate any such positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.
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Comments (4)
secound, Can companies purchase shares whenever they want or is there a specific window of time during which it is only possible?
