How Share Buybacks Work

Understanding how share buybacks work for a company

Share buybacks, also known as share repurchases, occur when a company purchases its shares from the market to reduce the number of shares in circulation. It’s misunderstood by many investors, as they don’t know how share buybacks work and why a company would even need to initiate a buyback. They fail to understand that share buybacks can be extremely lucrative for a company when initiated for the right reasons.

They are designed to reward existing shareholders and provide them with more value for their money. When the number of shares in circulation drops, the price per share will increase, and that will mean shareholders will have more profits if they sell those shares in the market. This article will look at share buybacks, including their purpose and whether they are good news for investors.

What Are Share Buybacks?

When a company decides to repurchase its shares, it is known as a share repurchase or a share buyback. There may be several reasons why a company would opt to buy back its shares, which may include the following:

  • It feels the current shares are undervalued
  • It wants to reward existing shareholders
  • It wants to improve key metrics
  • It wants to increase share price

The number of shares in circulation decreases when a company buys back its shares, which will mean fewer shares in the market. The result is an increase in share value or price, and that will mean existing shareholders will have a chance to earn more profit if they sell those shares.

The most common reason for a share buyback is that the company feels its current shares are undervalued in the market. Therefore, it will buy back all of its shares in the market, which will create demand for the shares. When there are fewer shares in the market, it will raise the value of the shares even if it is temporary.

Are Share Repurchases Beneficial?

Share repurchases have been criticized by economists who claim that it is an artificial method for increasing share prices and an accounting trick used by CEOs to boost their earnings per share numbers. However, when done right, share repurchases can be incredibly beneficial to a company. It helps them reduce the number of shares in existence and ensures that the share price doesn’t drop below the margin the company has set.

Even though companies who engage in share buybacks are looked at with skepticism, they are only doing that to survive when you look at the bigger picture. They may be better suited to spend their money on hiring new talent or research and development, but share repurchases also provide them with a solution to their problems.

Do Share Buybacks Really Destroy Long-Term Value?

he long-term impacts of share buybacks on companies

One of the most controversial corporate decisions under fire today is share buybacks. Politicians have claimed that share buybacks tend to create a ‘sugar high‘ for corporations as it helps boost prices up in the short-term. However, the best way to boost a corporation’s value is through investment in the company’s future, and most corporations aren’t doing that today.

The main reason why share buybacks are under fire from all quarters is that they prevent investment in new products and on employees. They are conveniently held up as a positive thing for investors and shareholders, while the general public suffers. Share repurchases also help increase the stock price in the short term, allowing opportunistic CEOs to cash out their shares. The accusation that CEOs enrich themselves through stock buybacks isn’t a new one and has been around for some time. The main concern for people isn’t that CEOs are enriching themselves but whether share buybacks are great for the long-term?

This question can be answered by looking at the market dynamics and studying the current trends in the market. The evidence clearly suggests that money invested in a buyback can’t be invested anywhere else. But is it always suitable for a company? When a company decides to repurchase its shares, it is actively choosing not to invest in its future, which isn’t great for its long-term value. However, the other end of the argument is that CEOs decide between good and bad investments for the betterment of their corporations. If they think that a share repurchase makes sense and will help the company, they must stand by their decision no matter how unpopular it may be.

Numerous studies have found that share buybacks occur when companies have excess capital and lack growth opportunities. That suggests that companies decide what investment decisions make sense and then decide to buy back any shares. That makes sense and goes against the general opinion surrounding share buybacks. However, in some cases, buybacks can destroy long-term value for a company. A company that isn’t focused on its long-term goals and wants to profit in the short-term with a buyback will not consider its impact on employees and their future products. That is where the negative press from share buybacks comes.

So does it make sense for a company to repurchase its shares? Yes, it does, but it shouldn’t come at the expense of their long-term growth. If a company isn’t investing in its future and is only focused on short-term gains, it will not succeed in the long-term. There must be a healthy balance between how a company decides to use the excess cash. It could either be used to train employees and invest in new products or can be used for share buybacks. 

What Are the Different Types of Share Buybacks?

Understanding share buybacks and their different types

A share buyback takes place when a company decides to buy back its outstanding shares from shareholders with borrowed funds or excess cash. This helps in reducing the number of shares available, which raises the value of the remaining shares. Companies also use share buybacks as a way to pay back investors. Most share buyback plans are proposed by the senior executives, and the company’s board authorizes a buyback.

However, announcing a share buyback doesn’t mean that it will take place because sometimes the tender offer may not be accepted, and the share price the company set may not be met. In some instances, a company may initiate a share buyback program to prevent a third party from buying a controlling share of the company’s stock.

Types of Share Buybacks

Two main types of share buybacks may be initiated by the company. To ensure that you get the complete picture, we will share details about them here.

1. Open Market Buybacks

In such instances, a company may buy back shares from the open market at a selected time or when the company management decides it is the best use of their capital.

2. Tender Offer

In this case, the company will offer to repurchase its shares, mostly at a higher price than what the shares are worth on the open market. The Securities and Exchange Commission will regulate all tender offers. A third party that wants to buy a controlling share of the company may also submit a tender offer, and in such cases, it is not a buyback but is known as a third-party tender offer.

Buyback Alternatives

Share buybacks offer a company a way to use its capital and increase value for shareholders. They can try and use other alternatives to buybacks as well. These will include the following:

  • Cash on hand is returned to investors as dividends
  • Capital is reinvested in research and development
  • Capital is used to acquire other companies or securities

It is important to understand the alternatives to share buybacks because, in recent times, buyback programs have been scrutinized and seen in a negative light.

Conclusion

In general, share buybacks are seen as a positive signal from the company, as it is mainly carried out to raise value for shareholders. A company may choose from several options when it comes to deciding what share buyback program to use. That is why it is important to know the different types of share buybacks and how they work. This will give you a better understanding of how share buybacks are used by companies and whether they are in your best interests as an investor.

Advantages and Disadvantages of Share Buybacks

Highlighting the main pros and cons of share buybacks for companies

These days, many companies are currently employing share buyback programs to improve the share prices and move the company forward. Share buybacks are a positive intention by the company with many advantages to be gained. However, in some instances, it can also backfire as there are some disadvantages of share buybacks. We are going to look at both of them in detail in this post to better inform you.

It should be first noted that share buybacks occur between two parties, the company and the shareholders. There are also several methods through which share buybacks occur, which gives companies a greater range of options when considering implementing a share buyback program. If you think that share buyback is something your company should be interested in, here are the advantages and disadvantages of share buybacks.

Advantages of Share Buybacks

* Greater Flexibility

By nature, share buybacks are flexible because the share buyback program is implemented for a long period, which is different from cash dividends, as they have to be paid straight away. The company is also under no obligation to conduct the share buyback program, as it has the authority to either modify it or cancel it depending on their needs. The shareholders also have freedom of choice since they can hold on to the shares and not sell them back to the company.

* Tax Benefits

In certain countries, share buyback programs offer tax incentives to the company. They have lower capital gain tax in comparison to the dividend tax rate. Also, share buybacks are taxed under the category of capital gain taxes, which means investors will be interested in share repurchase instead of cash dividends in these countries.

* Can Be Used as a Signal

In general, share buybacks are seen as a positive signal because the company thinks its shares are undervalued and is confident that they will grow. There is also the possibility that the company doesn’t have any profitable opportunities for reinvestment, and that’s what’s making it repurchase the shares. That is a negative signal for investors, and they can analyze this to understand which direction the company is heading.

Disadvantages of Share Buybacks

* Unrealistic Picture of Ratios

The share repurchase program can improve certain ratios such as ROE, EPS, and ROA. The increase in the ratios is mainly down to reducing outstanding shares rather than profitability, which isn’t an organic profit growth. Therefore, the share buyback can paint an unrealistic picture about the performance of the company.

* Judgment Error in Valuation

Even though the company’s management has access to all the insider information, they can still make an error in the company’s valuation. If the repurchase was implemented to support the undervaluation, but the company didn’t properly estimate the prospects, it will make the entire buyback program unnecessary.

3 Reasons Why A Company Should Consider Share Buybacks

The instances where share buybacks make perfect sense for a company

An increasing number of companies are announcing share buybacks. The directors may believe that share buyback will positively impact shareholders and the business as a whole. That’s why we will be looking at some of the most common reasons why a company would want to repurchase its shares and what benefits the shareholders will get as a result.

1. Take Advantage of Undervalued Share Price

One of the main reasons a company would think about repurchasing its shares is when the management believes that the company’s current shares are undervalued in the market. So, instead of keeping cash in the bank, the management decides to repurchase shares of the company at what they believe is a low price. There are two effects this buyback will have on the stock of the company:

  • The number of outstanding shares is reduced, and the pressure to buy increases as the company is buying its shares.
  • Management reassures the market that they are confident in their business operations when they spend millions to buy back their shares.

These two effects encourage investors to buy shares of the company. The market thinks that the management is only buying their shares because they believe that the value of these shares will rise in the future.

2. Increase Ownership and Reduce Dilution

Companies start issuing new shares over time through capital raisings or by exercising options, which reduces the dilution of existing shareholders. When a company repurchases its shares, it reduces the impact of that dilution. Reducing the number of outstanding shares also increases the ownership of the management of the company.

3. Enhancing Financial Ratios

Even though enhancing the financial ratios of the company isn’t the main reason for share buybacks, it is often a benefit that they gain when engaging in this activity. When the number of outstanding shares is reduced, it has a positive impact on the different ratios that are closely tracked in the market. These are known as the Return on Asset (ROA), Return on Equity (ROE), and Earnings per Share (EPS).

How Can Shareholders Benefit from a Share Buyback?

Share buybacks are a strategy from the capital management and are seen as a reward or benefit to shareholders. Even though investors benefit from dividends, when money is directly deposited into the bank account of the shareholder, there are indirect benefits of share buybacks. We have already highlighted that reducing the number of outstanding shares in the market increases the share price.

The company returns cash to the shareholders and provides investors with the chance to cash in on their investment. The management shows their confidence in the company, which positively affects the market sentiment regarding the stocks.

4 Reasons Investors Like Share Buybacks

The main reasons why share buybacks are good news for investors

Companies that are successful generally get to a position where they generate more cash than they can reinvest back into the business. The market conditions have meant that investors are now putting pressure on companies to distribute all the wealth they have accumulated back to their shareholders. In general, companies have several options for returning wealth to shareholders by using dividends, stock price appreciations, or share buybacks.

Dividends had been the commonly used form of distributing wealth to shareholders, but in recent times, buybacks have been seen as the best option for returning extra cash flow. Buybacks are valuable to investors who can turn their shares into gains in the future and defer on taxes. Buybacks also tend to benefit investors by returning money to shareholders efficiently and by increasing the prices of the shares. Here are some more reasons why investors like share buybacks:

1. Improves Shareholder Value

Profitable companies can use several ways to measure the performance of their stocks, but the most common measurement is going to be earnings per share (EPS). These are generally viewed as the most important variable when determining the prices of shares. When companies start to use share buybacks, they will be reducing assets on their balance sheets and improves their return on assets. Taking this measure reduces the number of shares outstanding and maintains a similar level of profitability.

2. Raise in Share Prices

Share prices can decrease when the economy isn’t doing well due to weaker than expected earnings. When this happens, a company will think about using a share buyback program as it believes that the shares of the company are undervalued. Most businesses will repurchase their shares and then sell them in the market when the price increases to reflect the company’s actual value. When the earnings per share start to increase, it will be seen positively by the market, and when buybacks are announced, it will raise share prices.

3. Tax Benefits

When there is excess cash used for buying back the company stock, rather than using it to raise dividend payments, it will allow shareholders to get rid of capital gains when the share prices increase. In general, buybacks aren’t highly taxed when compared to dividends, and this is good news for investors who are trying to get the maximum profit. They will not have to worry about paying a lot of taxes when they are buying back shares.

4. Uses Extra Cash

Investors get the message that the company has excess cash on hand when they know that the company has started a buyback program. This development means that investors don’t need to worry about cash flow problems and can concentrate on other matters. It also gives investors the signal that the company wants to use cash to reimburse shareholders rather than reinvesting in assets.

What Are Share Buybacks?

Understanding share buybacks and why companies use them

Companies can distribute cash to their stockholders through share repurchase, but for these to be effective, share buybacks have to be done at the right time and for the right reasons. Share buybacks are one-way stockholders can cash in on an investment. Still, anyone considering selling their holdings should try to understand why a company is choosing to buy back stock and how that move may affect its prospects. Share buybacks can be beneficial, but whether you win or lose when presented with a tender offer will partly depend on the state of the company’s balance sheet and its growth prospects.

What’s a Share Buyback?

A share buyback or repurchase is when a company puts out a tender offer telling shareholders it’s willing to buy back its shares at a certain price. That price is usually higher than what the stock is currently trading at. Shareholders can then submit written offers, which the company can accept or reject, as it tries to buy back its stocks at the lowest price.

Share buybacks can be done on the open market, but it’s not the preferred option for most companies since this tends to increase the share price. If a company announces that they will buy back shares, the price jumps very often because (it’s seen as a sign) that the company believes that the stock is undervalued.

Why Would a Company Buy Back Its Shares?

While there are several reasons why a company might repurchase its shares, the only reason it should is if its leadership does believe that the shares are undervalued. If it’s the other way around, it will be detrimental to the existing shareholders. However, companies can also opt to buy back shares to reduce their cost of capital.

That’s because a company’s capital structure comprises equity, debt, and existing cash. This cash from operations is the cheapest source of capital, but it’s also the money the company may need for ongoing operations and growth. Debt is the second cheapest form of capital the company has, followed by equity – its shares – which is the most expensive.

Sometimes if they repurchase their shares, especially if their shares are undervalued, they can reduce their cost of capital and get a more preferred capital structure. It’s also a way to give shareholders cash other than a dividend. A company may also be tempted to buy back shares if it feels its stock is being unfairly beaten down in the market and wants to stop the losses.

A company may repurchase to make its financial ratios look better, given that buying back shares will reduce the earnings per share but increase the price earning, or P/E, ratio. This can also increase the company’s return on equity because there is less equity.

Do Share Buybacks Deserve More Regular Scrutiny

The impact of share buybacks and whether they should be scrutinized

In 2020, U.S. companies spent $1 trillion to buy back their shares, while they spent $4 trillion to do so between 2008 and 2019. This is raising strong criticism from different quarters in the political sphere, as not only do key Democrats consider it an anathema, but Republicans also proposed to end the preferential tax treatment of share buybacks.

There is no substantial financial and economic difference between the distribution of a special dividend and a share buyback. However, dividends are taxed immediately, while share buybacks induce an unrealized gain until shares are sold, allowing for tax deferral. From a policy perspective, the sudden surge of buybacks could be explained as an unintended consequence of the recent tax cuts.

Should legislators address buybacks? One might argue that U.S. stocks will lose the major support they get from buybacks as the quality of corporate debt deteriorates and economic growth slows. However, regulators may still take a closer look.

Corporations Need Equity Flexibility

The debate on buybacks revolves around the greed of corporate management and the spending of money to benefit shareholders rather than the wider economy. However, to assess the validity of these concerns, it is important to look at the economic fundamentals of why buybacks make sense from a balance sheet standpoint.

In a number of ways, companies manage their equity to maintain the equilibrium between financial stability and their funding cost. Share buybacks create double leverage. They reduce the equity, and they increase the debt or reduce the cash. They have, therefore, a serious impact on the robustness of the balance sheet of companies. If a company decides to increase or decrease its capital, it must be for structural and long-term reasons.

Therefore, a share buyback should occur for structural reasons and a view to the long-term balance sheet. A few key examples of when a share buyback might be sensible are:

  • A structural change of a company business model
  • An excess of cash on the balance sheet that is unlikely to be deployed by investments or acquisitions
  • A structural under-leverage that will not be corrected in the foreseeable future
  • A clear desire to create long-term shareholder value

A share buyback is the opposite of an increase of capital needed to finance growth. In a sense, a share buyback recognition that the company doesn’t have anything better to do with its money than return it to shareholders.

The Process of Deciding on Buyback Shares

Buybacks should resonate with a company’s views of its financial stability, investments, acquisitions, strategy, and business model. Good governance practices should, therefore, be used in reaching buyback decisions, especially since a buyback can affect the very voting metrics with which it’s decided.

A blanket authorization at a company’s annual shareholder meeting to the management proposing a buyback is weak governance. Management should explain the impact of a buyback and why the company doesn’t need equity for the foreseeable future, despite its growth strategy. The board of directors is rarely presented with such an explanation and tend to assume buybacks create shareholder value, which is just one of their mandates.