It is possible for a corporation to return wealth to its shareholders in a variety of ways. Although stock price appreciation and dividends are the most common methods of sharing wealth with investors, there are a variety of other methods available. One of those methods that is often overlooked is share buybacks or repurchases, which will be discussed in this article. We’ll go over the specifics of how a share buyback works, as well as what it means for investors.
The Most Important Takeaways
- When a company buys back its own stock from the market, this is referred to as a stock buyback.
- It has the effect of reducing the number of outstanding shares on the market, thereby increasing the ownership stake held by the participants.
- A company might repurchase shares because it believes the market has overvalued its stock, in order to invest in itself, or in order to improve its financial ratios, among other reasons.
What Is a Stock Buyback and How Does It Work?
A stock buyback, also known as a share repurchase, occurs when a company buys back its own shares from the market with the money it has accrued over the course of the year. In order for a company to reinvest in itself, it may choose to buy back its own stock.
The repurchased shares are absorbed by the company, resulting in a reduction in the number of outstanding shares traded on the market. There are fewer shares on the market, resulting in an increase in the percentage of ownership stake held by each investor.
What Is the Process of a “Buyback”?
Companies can conduct a buyback in one of two ways: through a tender offer or by selling their stock on the open market.
1. The Tendering Offer
Upon receiving a tender offer, company shareholders are asked to submit a portion or all of their shares to the company within a specified time period. The offer will specify the number of shares the company wishes to repurchase as well as the price range at which the shares will be purchased. Investors who accept the offer will specify how many shares they wish to tender, as well as the price they are willing to accept in exchange for their shares. Once the company has received all of the offers, it will determine the best combination of offers to purchase the shares at the lowest possible price.
Buybacks are widely considered to be positive indicators for a company by the market, and the stock price often rises immediately after a buyback is announced.
2. Make the market available.
A corporation can also purchase its own stock on the open market at the current market price. However, it is frequently the case that the announcement of a buyback causes the stock price to rise sharply because the market perceives it as a positive signal from management.
The Reasons for Doing IT
Why do companies repurchase their stock? The management of a company is likely to conclude that a buyback is the most efficient use of capital at that particular time. Because, after all, the goal of a company’s management is to maximize return for shareholders, and a buyback typically increases the value of the company’s stock. When a buyback press release is issued, the standard line is “we don’t see any better investment than investing in ourselves.” Despite the fact that this is sometimes the case, this statement is not always correct.
There are a variety of other rationales that companies use to repurchase their stock. For example, management may believe that the market has discounted the company’s stock price too much. A company’s stock price can be slashed by the market for a variety of reasons, including weaker-than-expected earnings results, an accounting scandal, or simply a weak overall economic climate in which to operate. As a result, when a company spends millions of dollars to buy back its own stock, it may be a sign that management believes the market has discounted the stock too far, which is a positive sign.
Financial Ratios Need to Be Improved
Another reason a company might pursue a buyback is solely for the purpose of improving its financial ratios—the metrics that investors use to determine the value of a company. This is a questionable reason for doing so. If reducing the number of shares is a strategy to improve the financial ratios rather than to increase shareholder value, there may be a problem with management’s decision-making.
A good buyback decision, on the other hand, can result in improved financial ratios as a byproduct of a sound corporate decision if the company’s motivation for initiating the buyback is sound. Let’s take a look at how this occurs.
First and foremost, share buybacks help to reduce the number of outstanding shares. Once a company has purchased its shares, it is common for it to cancel them or hold them as treasury shares, thereby reducing the number of shares in circulation.
Furthermore, buybacks reduce the value of assets on the balance sheet, in this case, the amount of cash available. As a result, return on assets (ROA) increases due to the reduction in assets, and return on equity (ROE) increases due to the reduction in the amount of outstanding equity. In general, the market considers higher returns on assets and returns on equity (ROA and ROE) to be positive.
Consider the following scenario: a company repurchases one million shares at $15 per share, for a total cash outlay of $15 million dollars. The components of the return on assets (ROA) and earnings per share (EPS) calculations, as well as how they change as a result of the buyback, are detailed below.
According to the information provided, the company’s cash reserves have shrunk from $20 million to $5 million. Because cash is considered an asset, this will result in a reduction of the company’s total assets from $50 million to $35 million. Even though earnings have remained unchanged, this results in an increase in return on assets (ROA).
A year before the buyback, the company had a return on assets of 4 percent ($2 million/$50 million). Following the repurchase, the return on assets (ROA) increases to 5.71 percent ($2 million/$35 million). The earnings per share (EPS) increases from 20 cents ($2 million/10 million shares) to 22 cents ($2 million/9 million shares), which is comparable to the previous increase.
The buyback also has the additional benefit of improving the company’s price-earnings ratio (P/E). The price-to-earnings ratio (P/E ratio) is one of the most well-known and widely used measures of value. At the risk of oversimplifying, the market frequently believes that a lower price-to-earnings ratio is preferable. Consequently, assuming that the stock price remains at $15, the P/E ratio before the buyback is 75 ($15/20 cents) before the buyback.
Because of the reduction in the number of outstanding shares, the price-to-earnings ratio falls to 68 ($15/22 cents) following the buyback. In other words, fewer shares plus the same earnings result in higher earnings per share, which leads to a higher price-to-earnings ratio.
As a measure of value, the company is now less expensive per dollar of earnings than it was prior to the repurchase, despite the fact that earnings have not changed since the purchase was made.
In the short term, a stock buyback will always increase the value of the stock and benefit the shareholders who purchased the stock.
Yet another reason for a company to proceed with a buyback is to mitigate the dilution that is frequently caused by generous employee stock option plans (ESOP).
In times of rising markets and strong economies, the labor market can become extremely competitive. Companies must compete with one another in order to retain employees, and employee stock ownership plans (ESOPs) include a variety of compensation packages. Upon exercising their options, stockholders receive a different result than they would from share repurchases, as they increase the number of shares in circulation.
As illustrated in the preceding example, a change in the number of outstanding shares can have an impact on key financial measures such as earnings per share and price to earnings ratio (P/E). A change in the number of outstanding shares has the opposite effect of repurchase in the case of dilution: it makes the company’s financial position appear weaker.
The earnings per share (EPS) would have decreased to 18 cents per share from 20 cents per share if we assumed that the number of shares in the company had increased by one million. The decision to repurchase shares may be made by a company after years of lucrative stock option programs are completed in order to avoid or eliminate excessive dilution.
Profits from Taxation
Because a buyback is similar to a dividend in that the company is distributing money to shareholders, although in a different way, they are often confused with one another. Historically, one of the most significant advantages of buybacks over dividends was that they were taxed at the lower capital-gains rate, as opposed to the higher dividend tax rate.
Dividends, on the other hand, are taxed at ordinary income tax rates at the time they are received by the recipient. 1 Tax rates and their effects typically change on an annual basis; as a result, when comparing the benefits of capital gains versus dividends as ordinary income, investors take the annual tax rate on capital gains into consideration.
What’s the bottom line?
Are share buybacks a good thing or a bad thing? As is so often the case in finance, there may not be a definitive answer to the question at hand. Buybacks reduce the number of shares outstanding as well as the total assets of a company, which can have a variety of consequences for the company and its investors in a variety of ways.
When key ratios such as earnings per share and price to earnings (P/E) are considered, a decrease in the number of shares outstanding increases EPS and lowers the P/E, resulting in a more attractive value. Return on assets (ROA) and return on equity (ROE) improve as the denominator decreases, resulting in an increase in return.
In the public market, a buyback will always result in an increase in the value of the stock, which is to the benefit of the shareholders. The question for investors, however, is whether a company is merely repurchasing shares to prop up ratios, provide short-term relief to a declining stock price, or to get out from under the burden of excessive dilution.