What is Share Buyback?
Share buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet thereby raising the worth of remaining outstanding shares or to block the control of various shareholders on the company.
Share buyback has increasingly become common since around the start of the 21st century. It is nothing but a company buying its own shares. It was also considered “abnormal” earlier than that because it seemed like the company is planning roll back its IPO leaving no chance for the remaining shareholders to ever see the stock recover. But toward the end of the last century, the rise in the volume of share repurchases had started and continued till the early years of this century after which it became a “normal” phenomenon.
For example, the total value of shares repurchased in the US in 1980 was $ 5 billion while the same metric ballooned to $ 349 billion in 2005.
Share Buyback Examples
Colgate’s Board authorized Share buyback with the aggregate repurchase of $5 billion under the 2015 Share buyback program
source: Colgate 10K
Top Reasons for Share Buyback
There is only a limited number of reasons for a company to buy back its own shares. They are listed below:
#1 – Taking advantage of undervaluation of the shares by the market
Once the shares of a company are issued into the primary market, they eventually move into the secondary market and keep floating there, changing hands from one investor to the other. It is the public that buys and sells the company’s shares in the secondary market.
- If there are more shares bought than sold, the stock price increases and if there are more shares sold than bought, the stock price decreases.
- However, when the latter happens, and the stock price of the company’s shares decreases, the company investigates the reasons behind it. Among the most common reasons, which doesn’t need an investigation, is poor financial performance reported/implied by the company’s results announced.
- Other than this, some negative news floating in the market can also, make the shareholders pull back from the company’s stock and result in a decrease in price. If the reasons behind the decreasing stock price are one or more of the above and are real, then the company can’t help but work toward correcting its mistakes and addressing those issues.
- And if the market has already taken such factors into consideration, the decrease in stock price is obvious and the stock is fairly valued.
- But in some scenarios, the stock price falls down to not so obvious low levels due to a lack of buying interest among the investors. This is because more and more investors don’t value the company as much as its value is based on its financial statements. In other words, the stock is undervalued by the market.
- In this case, the company’s management has the opportunity to buy the shares back at a price below their intrinsic value. Later, the market is bound to correct the undervaluation as per the thesis of fundamental analysis. When the correction takes place, the stock price appreciates closing to the intrinsic value.
- At this time, the company’s management can benefit by reissuing the shares at an increased price since the market now values the stock higher. In this way, the company increases its equity capital without issuing any additional equity.
Apple Repurchased $14 billion of its own shares in two weeks after reporting disappointing financial results. “It means that we are betting on Apple,” Mr. Cook said.
“We are really confident about what we are doing and what we plan to do. We are not just saying that. We are showing that with our actions.” Mr. Cook added.
Sometimes the undervaluation of the stock is so much that the company is ready to offer to pay a premium to the interested sellers over the market price. This type of buyback is also called fixed price tender offer (you will see this in the later section)
#2 – A tax-efficient cash distribution alternative to dividend pay-out
When a company disburses dividend, there are immediate and higher tax implications. Similarly, when the company distributes the cash by doing share buyback, the tax rate is not as much as in the case of dividends. So by buying back the shares, the company is anyway returning a portion of its earnings and cash generated. But the net shareholder value is ensured by share buyback because of lower tax implications. However, in some countries including the US, the tax laws have now been modified resulting in the tax rate on capital gains from share buy-backs that have become equal to that on dividend distribution.
Here you can easily take India as an example, where taxes have tilted scales in favor of buybacks compared to dividends
#3- Reduction of float and increment of earnings per share
- Sometimes a company also repurchases its own shares in order to reduce the float or the number of publicly traded shares. By doing so, the denominator of one of the most important fundamental ratios, “earnings per share (EPS)”, gets reduced while there is no effect on the numerator i.e. the profit by this act. Hence, earnings per share increase which could result in increased buying interest for the company’s shares which means increased shareholder value and thus happy shareholders.
- Similarly, other financial ratios can also be improved by doing share buyback. In fact, the company’s sometimes do share repurchase solely with the aim of improving these ratios since the potential investors watching the market generally take these ratios into consideration. Do have a look at this detailed guide on Ratio Analysis for further understanding
- What happens in the process of the share buyback is that the company doles out its cash in exchange for its shares. Now, cash is an asset on the balance sheet. So during share repurchase, there is a reduction in the assets of the company. Again mathematics comes into the picture and the denominator of another ratio i.e. “return on assets (ROA)” gets reduced without affecting the numerator. Hence, the return on assets also increases.
- Similarly, since some shares have been bought back by the company, the outstanding equity floating in the market gets reduced. As a result, the return on equity (ROE) also increases. In the same manner the “price to earnings (P/E)” ratio decreases because of an increase in EPS. And a decrease in the P/E ratio is seen as a good sign by the market since it means higher earnings for a lower share price.
- One must watch out for such motives of the company behind a buyback because such acts don’t enhance the shareholder value in reality.
- But sometimes the purpose of reducing the float is just the reduction of the float instead of playing with the financial ratios. Employee stock option plans (ESOP) are a kind of employee compensation that companies often choose in order to retain their top-level and important employees. By doing so, the company gives the holders of the options a right to own a certain number of shares in the company. And whenever they find it appropriate, they can exercise the options and sell those shares at the market price. When the employees do so the number of outstanding shares increases in the market over a period of time resulting in the dilution of the company’s equity.
- When there is too much equity dilution, which is often caused by very generous employee stock option plans (ESOP), the company counters it by buying back its shares from the market. By doing so, the company increases the proportion of shares owned by enduring investors. This acts as a safeguard against a hostile takeover as well.
Also, see how the management can look at reducing the number of outstanding shares using the Treasury Stock Method
As noted by Amigobulls, IBM shares repurchase to achieve the EPS target set by the company. The management wanted to achieve a target EPS of $20 by 2015. Therefore they resorted to a very strong buyback program which in turn is leading to an increase in EPS
#4 – Boosting the stock price
Simple supply-demand dynamics come into play here. As the company buys its shares back, the supply of shares in the market gets reduced without affecting the demand. Hence, the share price is likely to increase as a result of reduced supply.
#5 – Maintaining the dividend pay-out ratio despite having excess cash
- Paying regular dividends is important for a company, at least in the eyes of its shareholders. And logically, the dividend must be proportional to the free cash generated before dividend distribution. However, the cash generated before dividend distribution cannot be ever-increasing and can’t even remain constant during each period after which dividend is distributed. It fluctuates.
- Hence, dividend can’t be kept proportional to the cash generated. Instead of that, it is preferable to pay a constant dividend. Otherwise when more cash is generated, the dividend increases. But when the cash generated decreases, the dividend also needs to be decreased.
- A decrease in dividends might just send a wrong signal into the market. That is why maintaining a near-constant dividend pay-out ratio and that too a regular dividend pay-out is advisable.
- Due to the above reasons, companies don’t generally increase the dividend too much even when they generate a huge amount of cash compared to that generated during the previous reported period. Still, in order to ensure higher returns to shareholders due to higher cash generation, the company’s management often decides to pay a part of the excess cash to the shareholders by offering to do share repurchase shares.
- In this way, the company avoids the possibility of fluctuating dividends while still returning a higher amount of cash generated to the owners as and when possible.
#6 – Avoiding excessive cash accumulation and potential takeover
- Having excess cash with no plans for investment in the foreseeable future does no good for a company. What is the harm in having too much excess cash? Companies with strong cash generation and limited CAPEX requirements do accumulate cash on the balance sheet.
- This accumulation of excess cash makes the company a more attractive target for a potential takeover. Why so? Because even if the other company, interested in taking over the target company, doesn’t have the means to finance the takeover, it might as well finance it with debt and later use the cash accumulated on the balance sheet in order to pay down the debt incurred to carry out the acquisition.
- It is this threat that companies often try to avoid by using up the excess cash for share repurchase and maintaining a lean cash position. The share buyback also avoids a takeover in one more way.
- It boosts the stock price as discussed in one of the above sections. By doing so, it makes the takeover itself more expensive. Therefore, a share repurchase is also used by companies as a part of their anti-takeover strategy.
For example, as noted by Amigobulls, In Mid-2007 buyout firms were going aggressive and leaving no opportunity to buyout efficient firms. As a reaction to this Expedia authorized a share buyback in June of 2007 to protect itself against a buyout. Its outstanding shares figures of FY 2007 and FY 2012 reveals that the outstanding shares have decreased by 183.82 million shares or a reduction of 56% in a number of outstanding shares.
Effects of a Share buyback – Example & Calculation
Suppose there are 10 million shares of the company outstanding in the market and the stock price before buyback is $ 10.0. At this price, the company buys back 1 million shares leaving only 9 million shares in the market. Since the initial stock price was $ 10.0, the company would have used up $ 10 million for the buyback. So if the company initially had $ 50 million on its balance sheet, it would have only $ 40 million after the buyback. Assuming no change in any other asset, the total assets will also come down by the same amount i.e. $ 10 million. The total earnings won’t be affected by the buyback. So assume no change in earnings.
The following table shows how various important parameters change when a share buyback operation is carried out:
- Effect on EPS, ROA, and ROI due to Share Repurchase – Now, the ratios EPS, ROA and ROI are equal to Earnings divided by Shares Outstanding, Total Assets and Equity Outstanding respectively. As you can see in the table, the Earnings have not changed but the latter 3 terms have decreased as a result of the buyback. Due to this, the three ratios EPS, ROA and ROI have also increased.
- Effect on PE Ratio on account of Buybacks – The stock price has increased from $ 10.0 to $ 10.5 due to a reduced supply of shares in the market. And the P/E ratio is equal to the stock price divided by EPS. Here the Stock price has increased by only 5 % while the EPS has increased by 10 %. As a result of a greater increase in its denominator, the P/E ratio has decreased which makes the company more attractive for investment. However, since the numerator and denominator of the P/E ratio are independent and can change by different proportions in different cases, an improvement in P/E can’t be guaranteed as a result of a buyback. The other ratios mentioned above certainly get better after a buyback.
Share Buyback Methods
There are generally three common methods adopted by companies for doing share repurchases.
Open Market Share buyback
- The most common of those methods is the “open market repurchase”. Almost 75 % of all share repurchases in the US are done using this method. When doing it by this method, the company makes a public announcement that it will be buying back its shares over a period of time from the open market from time to time as market conditions dictate.
- The share buyback program doesn’t end with a single transaction. According to the prevailing market conditions from time to time, the company decides upon the feasibility, the timing and the volume of shares to be repurchased through each transaction. That is why open market repurchases often take months or even years to get completed.
- Although, the decision of the repurchase volume is in the hands of the company, there exist certain daily buy-back limits that restrict the amount of stock that can be bought over a particular time interval again ranging from months to even years. For example, in the US the SEC Rule 10b-18 dictates that the issuer can’t repurchase more than 25 % of the average daily volume.
- Since the volumes involved in this repurchase method are huge, it greatly adds to the long-term demand for shares in the market and is also likely to affect the stock price till the time the repurchase operations continue.
An example is Celgene’s shares repurchased as “Open Market Repurchase”
Fixed Price Tender Share buyback
- A less common share repurchase method used by companies is the “fixed price tender”. In fixed price tender, the purchase price, the volume of shares repurchase and the duration of the offer are pre-decided and pre-specified by the company.
- And all this information is also made public through a mandatory public disclosure. The shareholders interested to sell their shares at the specified price express their interest.
- Then the total number of shares offered by all the interested shareholders is compared with the number of shares the company wanted to buy. If the former number is higher, the company buys equal to the latter number from the selected shareholders.
- But if the former number is lower, the duration of the offer is extended for more shareholders to express their interest.
An example is that of Schindler Holding Ltd plan to do share repurchase as a “Fixed Price Share Repurchase Offer”
Dutch Auction – Share buyback
- The third method of the share repurchase is the “Dutch auction”. In this method, the price of the repurchase is “discovered” like it is done in the case of an IPO.
- First, the price range is specified by the company. Then shareholders state their own comfortable price point within the specified range.
- Then the company creates a demand curve from those inputs from the interested shareholders. From the demand curve, the company finds out what would be the lowest price at which it could buy the required number of shares.
- Then the company buys the shares from those shareholders who had tendered at or below that found out the price.
Example of Dutch auction is Expedia planned to do share repurchase of up to $3.5 billion of Stock in the Dutch Auction
source: Payout Yield
Share Repurchase Video
There are a limited number of reasons why companies do share repurchase. They do it for the benefits that they are able to reap out of that activity. And in doing so, they also lure the shareholders into selling the shares to take some advantages like tax benefits.
However, it is in the favor of investors to stay watchful of misguiding buybacks and understand the meaning of it in the context of the situation in which a company announces a buyback.
This has been a guide to what is Share Buyback and its definition. Here we discuss the top 3 methods of share repurchase along with examples, and reasons. You may learn more from the following articles –
- Bond Sinking Fund – Example
- What is the Tender Offer?
- What is a Sinking Fund?
- Formula for Outstanding Shares
- Accelerated Buybacks
- Financial Ratios Limitation
- Contingent Shares Issuance Agreement
- Companies with Negative Shareholders Equity
- Shareholders Equity Formula
- Restricted Stock Units Tax
- Preferred Shares Meaning
- Calculate Diluted Earnings Per Share