There are a number of ways in which a company can return wealth to its shareholders. Although stock price appreciation and dividends are the two most common ways of doing this, there are other useful, and often overlooked, ways for companies to share their wealth with investors. We will look at one of those overlooked methods: share buybacks. We will go through the mechanics of a share buyback and what it means for investors.
A stock buyback, also known as a “share repurchase”, is a company’s buying back of its shares from the marketplace. You can think of a buyback as a company investing in itself, or using its cash to buy its own shares. The idea is simple: because a company cannot act as its own shareholder, repurchased shares are absorbed by the company, and the number of outstanding shares on the market is reduced. When this happens, the relative ownership stake of each investor increases because there are fewer shares, or claims, on the earnings of the company.
Typically, buybacks are carried out in one of two ways:
Shareholders may be presented with a tender offer by the company to submit, or tender, a portion or all of their shares within a certain time frame. The tender offer will stipulate both the number of shares the company is looking to repurchase and the price range they are willing to pay (almost always at a premium to the market price). When investors take up the offer, they will state the number of shares they want to tender along with the price they are willing to accept. Once the company has received all of the offers, it will find the right mix to buy the shares at the lowest cost.
2. Open Market
The second alternative a company has is to buy shares on the open market, just like an individual investor would, at the market price. It is important to note, however, that when a company announces a buyback it is usually perceived by the market as a positive thing, which often causes the share price to shoot up Now let’s look at why a company would initiate such a plan.
If you ask a firm’s management, they will likely tell you that a buyback is the best use of capital at a particular time. After all, the goal of a firm’s management is to maximize return for shareholders and a buyback generally increases shareholder value. The prototypical line in a buyback press release is “we don’t see any better investment than in ourselves.” Although this can sometimes be the case, this statement is not always true.
Nevertheless, there are still sound motives that drive companies to repurchase shares. For example, management may feel the market has discounted its share price too steeply. A stock price can be pummelled by the market for many reasons like weaker-than-expected earnings results, an accounting scandal or just a poor overall economic climate. Thus, when a company spends millions of dollars buying up its own shares, it says management believes that the market has gone too far in discounting the shares – a positive sign.
Improving Financial Ratios
Another reason a company might pursue a buyback is solely to improve its financial ratios – metrics upon which the market seems to be heavily focused. This motivation is questionable. If reducing the number of shares is not done in an attempt to create more value for shareholders but rather make financial ratios look better, there is likely to be a problem with the management. However, if a company’s motive for initiating a buyback program is sound, the improvement of its financial ratios in the process may just be a by product of a good corporate decision. Let’s look at how this happens.
First of all, share buybacks reduce the number of shares outstanding. Once a company purchases its shares, it often cancels them or keeps them as treasury shares and reduces the number of shares outstanding, in the process.
Moreover, buybacks reduce the assets on the balance sheet (remember cash is an asset). As a result, return on assets (ROA) actually increases because assets are reduced; return on equity (ROE) increases because there is less outstanding equity. In general, the market views higher ROA and ROE as positives.
The buyback also helps to improve the company’s price-earnings ratio (P/E). The P/E ratio is one of the most well-known and often-used measures of value. At the risk of oversimplification, when it comes to the P/E ratio, the market often thinks lower is better. Fewer shares + same earnings = higher EPS!
Based on the P/E ratio as a measure of value, the company is now less expensive than it was prior to the repurchase despite the fact there was no change in earnings.
Another reason that a company may move forward with a buyback is to reduce the dilution that is often caused by generous employee stock option plans (ESOP). Bull markets and strong economies often create a very competitive labour market – companies have to compete to retain personnel and ESOPs comprise many compensation packages. Stock options have the opposite effect of share repurchases, as they increase the number of shares outstanding when the options are exercised. As was seen in the above example, a change in the number of outstanding shares can affect key financial measures such as EPS and P/E. In the case of dilution, it has the opposite effect of repurchase: it weakens the financial appearance of the company.
In many ways, a buyback is similar to a dividend because the company is distributing money to shareholders. Traditionally, a major advantage that buybacks had over dividends was that they were taxed at the lower capital-gains tax rate, whereas dividends are taxed at ordinary income tax rates. However, with the Jobs and Growth Tax Relief Reconciliation Act of 2003, the tax rate on dividends is now equivalent to the rate on capital gains.
Are share buybacks good or bad?
As it is so often the case in finance, the question may not have a definitive answer. If a stock is undervalued and a buyback truly represents the best possible investment for a company, the buyback – and its effects – can be viewed as a positive sign for shareholders. Watch out, however, if a company is merely using buybacks to prop up ratios, provide short-term relief to an ailing stock price or to get out from under excessive dilution.