A share buyback is a situation where a company repurchases its own shares. It buys the shares at the market value and may destroy the reacquired shares or hold them in treasury. When a company buys its shares, it increases the stake of the remaining shares. The reduction in the number of outstanding shares increases the worth or stake of the remaining shares. Companies typically buy back shares when they have surplus cash available or want to increase the stake of its investors.
When public companies make profit, they usually split the profit into two. A part of the profit is used to pay dividends to shareholders or used to reacquire its shares. The second part is used for future expansion of the company, whenever there are profitable investments which the company can do. Future investments may be an increase in production capacity, or more funding for research and development, aiming at technological innovation. The end goal is for the company to attain a better financial position.
The Purpose of Share Buyback
Share buyback is an alternative means to compensate shareholders as opposed to dividends. When a company buys its shares, the number of outstanding shares in the market is reduced, hence the stake of the shareholders in the company is increased. If the profits remain the same, then with increased stake, it means that the earnings per share will also increase. What share buyback does is that it takes value from shareholders who are willing to sell and add to the non-selling shareholders. Companies are likely to successfully buy back a significant amount of their shares if the majority of the shareholders are retail owners who are unsophisticated and willing to sell in the short term.
Another reason companies engage in share buyback is to refrain from creating a fluctuating dividend. Companies have learnt over the years that shareholders are very intolerant of dividend cuts, but will tolerate cancelled share buybacks or delayed share buybacks. When there is excess profit, the management of the company does not want to increase dividend payment and then have to cut the payment of the dividend when the profit is no longer in excess. They instead pay an acceptable dividend and compensate the investors through share buyback programs.
Share undervaluation is another strong reason companies perform share buybacks. If a company’s executives believe that the current market value of their shares is below its intrinsic value, they may repurchase the shares. Most times, repurchase occurs in the open market where no premium is paid in addition to the market price. The company then holds the shares until the market value of the shares is equal to or above the price at which the shares were purchased. Share buybacks through the open market have the potential to become profitable.
Cash on the Balance Sheet
Share buybacks help companies shed off excessive cash that would have otherwise been accumulated in the balance sheet. This situation typically occurs in companies with limited capital expenses such as Tech firms who have high-income generation.
Share Buyback Example
Greenbelts, a hotel chain company has made $24,000,000 in profits this year. The previous year, they had made a similar amount of profit, $23,800,000. Investors are not impressed with Greenbelts because they have made only a 0.84% growth in profit. Greenbelts have 20,000,000 outstanding shares, at $10 per share, which gives it a market capitalization of $200,000,000. This means that for every share, the stake of the shareholder in Greenbelts is 0.000005%. Since the performance of Greenbelts is poor, its management has decided to increase the stake of its shareholders as an alternative to dividends. The management wants to use the $24,000,000 profit to buy back its shares.
With $24 million, Greenbelts can buy back 2,400,000 shares, bringing the total outstanding shares to 17,600,000. The 2,400,000 repurchased shares are taken out of the market and destroyed. The reduction in the number of shares makes the stake of the investors increase. Instead of the 0.000005% stake per share, the new stake is 0.0000057%. If profits remain the same the following year, the earnings per share will increase next year as there is a reduction in the number of shares outstanding.
The example illustrates how a reduction in the number of outstanding shares in the market leads to a rise in the stake of shareholders in a company.
Share Buyback Analysis
Share buyback is used by companies for different purposes. The aim at times is to boost the stake of shareholders in a company as an alternative way to paying dividends, or simply to reduce the cash available on a company’s balance sheet. Managers sometimes do buyback programs when they believe that the shares are undervalued. Managers can buy back shares in several ways.
Share Buyback Methods
The most common method of share buyback is the open market. In this method, the company announces the number of shares it wants to buy at the market price. The company holds the right to decide, based on market conditions, when to buy the shares and the number of shares to buy. This type of buyback can span months and even years.
The next method is the fixed price tender, where the company specifies the price and the number of shares and the duration in which the offer will last. All the conditions are fixed. Wiling shareholders then tender their shares to the company within the time limit.
The third method is the Dutch Auction offer in which the company specifies a range of prices at which it is willing to buy the shares and shareholders are invited to tender their stock at a chosen price within the price range. The company then decides which shares to buy depending on its demand curve.
Share buyback is useful for companies in avoiding conflict with shareholders through fluctuating dividends. It also provides companies with a means to eliminate accumulated cash, which will otherwise make the company attractive for takeover.
Share buybacks become disadvantageous if the company overprices the shares, as the shares will become a loss to the company when the share prices normalise. While investors will be happy about share buybacks, the company faces possible backlash from the public – why the profits are not used to increase staff salaries or expansion of the company.
Share Buyback Conclusion
- Share buyback is when a company repurchases its own shares.
- Companies use share buyback programs to increase the stake of shareholders in a company.
- Companies might also engage in share buyback to reduce the amount of cash on their balance sheet.
- A major disadvantage of share buyback is that the company might buy the shares when they are overpriced, leading to losses for the company.