Table of Сontents
- What Is A Share Repurchase or Buyback?
- Why Companies Buy Back Their Shares
- Types Of Share Repurchase Programs
- Pros & Cons Of Share Buybacks
- Impact On Business Valuation Of Share Repurchases
- Impact On Investors Of Share Repurchases
- Bottom Line
A firm can give money to its shareholders by repurchasing its own shares through share repurchases.
What Is A Share Repurchase or Buyback?
Companies repurchase shares of stock to lower the number of existing shares and increase the amount of future corporate earnings that each share represents.
Shares that are repurchased are either canceled, which lowers the total number of outstanding shares, or they are kept as treasury shares by the corporation. A percentage of a company’s shares that have either been repurchased or never issued at all are known as treasury shares. No payouts are made and no voting rights are attached to Treasury shares. If a business needs to raise money, these shares may be sold to the general public.
Public businesses usually say in a statement that the board of directors has approved a “repurchase authorization,” and the statement includes one.
- the entire sum of funds earmarked for share buybacks.
- how many shares it plans to repurchase.
- The proportion of outstanding shares that will be repurchased
Why Companies Buy Back Their Shares
When a business has more cash than it requires for ongoing operations or potential future growth, it has two options for returning part of that extra money to shareholders:
- Dividends: shareholder payments in cash on a regular basis.
- Share buyback: A business may purchase shares of its stock on the open market or through the tender of shareholder shares at a set price.
- A firm could decide to buy back part of its own shares for a variety of reasons.
1. The Stock is Undervalued
The board of directors of a firm may determine that the stock is undervalued as a result of a bear market, unfavorable press coverage of the company, or recent subpar performance. A corporation can sell the shares it purchases and holds onto them if the economy improves or the share price increases by doing so.
Let’s see an illustration of how this may function:
- The Marx Widget Company raises $40,000,000 in equity by issuing 1,000,000 shares at a price of $40 each.
- The demand for widgets suddenly declines, and Marx’s stock price falls to $30 per share.
- With the buyback of 166,666 shares by The Marx Widget Company for a price of $30 per share and a payment of $5,000,000, Marx’s total equity now stands at $35,000,000 ($40,000,000 – $5,000,000) and there are 833,334 shares outstanding. Each stakeholder now has a greater claim to Marx’s future earnings.
- When people learn how great widgets are, Marx’s stock price increases to $50 per share.
- Reissuing the 166,666 shares it had previously purchased at the current market price of $50 per share nets the corporation $8,333,300, bringing its total equity to $35,000,000 + $8,333,300 = $43,333,300.
- The company’s repurchase allowed it to:
2. To Make a Company More Attractive
The Marx Widget Company issues 1,000,000 shares at a price of $40 apiece in order to raise $40,000,000 in equity.
The price of Marx’s stock drops to $30 per share as a result of a significant downturn in the demand for widgets.
The Marx Widget Company purchased 166,666 shares for $30 each and made a payment of $5,000,000, bringing Marx’s total equity to $35,000,000 ($40,000,000 – $5,000,000) and the number of outstanding shares to 833,334 shares. Now, each investor has a stronger claim to Marx’s potential future profits.
When people realize how fantastic widgets are, the share price of Marx rises to $50.
The corporation earns $8,333,300 by reissuing the 166,666 shares it had previously bought at the current market price of $50 per share, increasing its total equity to $35,000,000 + $8,333,300.
- The Marx Widget Company has 1 million outstanding shares, makes $10 million in net profit annually, and has an EPS of $10.
- The Marx Widget Company has 1 million shares outstanding, a yearly net profit of $10 million, and an EPS of $10.
- The company’s profits per share (EPS) would be $10,000,000/900,000 = $11.11 without any actual earnings growth.
Types Of Share Repurchase Programs
1. Open Market
A corporation can purchase its shares back from the market at the going rate without having to pay a premium. The company’s brokers carry out the transactions, which might take a while when buying back a lot of shares. The corporation is not required by law to finish the buybacks through this technique, and it is free to end the repurchase program whenever it wants. The main benefit of this approach is that it is economical.
2. Fixed-Price Tender Offer
A corporation has the option to buy back its shares from the market at the current rate without incurring any additional costs. The transactions, which might take some time when purchasing a large number of shares, are carried out by the company’s brokers. The business is allowed to discontinue the repurchase program whenever it pleases; it is not obligated by law to complete the buybacks via this method. The key advantage of this strategy is that it is cost-effective.
3. Direct Negotiation
A corporation approaches a number of significant shareholders and makes an offer to purchase back their shares. With the shareholders, the corporation negotiates a repurchase price that often includes a premium. The direct bargaining approach’s key benefit is that it may be extremely cost-effective, but only in particular situations.
4. Dutch Auction Tender Offer
A corporation proposes to buy back shares from shareholders in a Dutch auction tender offer, but it doesn’t specify a price. Instead, it offers a pricing range with a minimum and a maximum, with the minimum typically being higher than the going rate. Shareholders reply by stating their willingness to sell and the lowest price they would accept for their shares. The business evaluates those offers and chooses a price from the predetermined range.
The key benefits of a Dutch auction tender offer are that the corporation may swiftly finish the repurchase and determine a share price based on shareholder opinion.
Pros & Cons Of Share Buybacks
Pros of Share Repurchase Programs
- Returns more to shareholders: A share repurchase enables a business to increase shareholder returns without committing to a dividend. A business may combine a share repurchase program with dividend payments. For instance, the Marx Widget Company may distribute 25% of its earnings as dividends and the remaining 25% as share repurchases if it wanted to return 50% of its profits to its shareholders.
- Keeps investors happy: Whether it takes the shape of a dividend or a repurchase, investors desire payouts.
- Tax implications: A share repurchase program has no immediate tax repercussions because there is no payout to shareholders, but wealthy stockholders may not desire the additional taxes that dividends bring. The “Build Back Better” proposal, which the White House launched in October 2021, however, suggests a 1% tax on buybacks, claiming that “corporate CEOs exploit [buybacks] too often to enrich themselves rather than investing [in] people and expanding their firms.” Additionally, in nations where the proceeds from stock buybacks are regarded as capital gains, the capital gain tax rate may be less than the dividend tax rate.
- Offset dilution: Offering stock options is a common strategy used by high-tech and expanding organizations to entice or retain outstanding staff. The total number of shares outstanding rises as a result of those options being exercised, which decreases each shareholder’s ownership stake in the firm and reduces the value in the hands of current shareholders. Companies can counteract this effect through share buybacks.
- Hostile takeover defense: A target company’s management can repurchase part of its shares to reduce the likelihood that a potential bidder will be able to acquire a controlling stake. Additionally, businesses may use the “poison pill” defense, which gives current shareholders the option to buy additional shares at a reduced price, reducing the hostile party’s ownership stake in the process.
Cons of Share Repurchase Programs
- Falling share prices: When the stock market is strong and the company is financially sound, they have the funds to buy back shares. Just at certain periods, the share price is likely to be high, and if either the market or the share price declines following the repurchase, it might have a detrimental impact on the business.
- Downgraded credit rating: A company’s credit rating will be negatively impacted if it must borrow money to support a leveraged buyback of its stock. If a company’s credit rating is reduced, it will be more expensive for it to borrow money from a bank or from investors if it issues bonds.
- Limited growth potential: Investors may assume from a share repurchase that a firm does not see many chances for growth or is not investing in R&D.
- Mask falling income: A share repurchase can hide a decline in net income by lowering the number of outstanding shares since the EPS will increase despite the decline in net income.
- Conceal stock-based compensation: Many public firms use stock as a form of compensation for their executives, which dilutes the value of the stock owned by other shareholders. Companies may conceal this type of remuneration through buybacks.
- Impact On Business Valuation Of Share Repurchases
A share repurchase lowers a company’s total number of outstanding shares as well as the total amount of cash it has on hand. A company’s earnings per share increases if its overall earnings remain constant while fewer shares are outstanding. The price-to-earnings ratio of a corporation will decrease if its stock price stays the same while its profits per share increase.
A company’s return on assets (ROA) will rise when a repurchase reduces the amount of cash on its balance sheet.
ROA stands for Return on Assets.
For instance, if the Marx Widget Company has a net income of $10 million and has assets valued at $100 million, its ROA is $10 million/$ 100 million, which equals 0.1 or 10%. Consequently, for
Impact On Investors Of Share Repurchases
Each surviving share increases in value as the number of outstanding shares decreases, but the fundamental advantage of buybacks for shareholders is that they enhance the measures we discussed above that are used to determine a company’s value.
A stock buyback may benefit investors if the firm is performing well and has the funds to carry it out. However, shareholders would ultimately lose value if the firm starts a repurchase to boost its share price while disregarding its potential for future development.