Why do companies buy back their stocks?
A stock buyback decision may send a questionable signal to investors. Not all buybacks will show the management’s opinion that the stocks are undervalued.
By Guy Avtalyon
A stock buyback or a stock repurchase refers to a situation when a company buys its outstanding shares. The reason is simple, they want to decrease the number of available stocks on the market. Did you know this practice was illegal in the past? Oh, yes! It was illegal because it was seen as a type of stock manipulation. Today, a stock buyback is legal, of course.
When a company buys its stocks it can cancel them or hold them for re-issue later. To perform a buyback, a company can get its stocks in the market like any other investor. Also, there are two other ways to do so. The company may announce a proportional offer and buy equivalent parts from its shareholders. The other way is a tender offer. This means the company invites its shareholders to sell stocks by buying back a fixed number of its stocks at a specified price.
Tender offers are made publicly. The company invites shareholders to sell their stocks at a specified price and usually, they have a defined time frame to do that. The price specified is often at a premium to the market price. It can be conditional upon a minimum or a maximum number of sold shares.
The law demands public companies to buyback stocks from funds generated from profits or the gains of a current issue of stocks.
Buyback can be offered over a specific period. For example, a company announces its plan to buy back $70 million worth shares in the next 3 years.
What are the reasons behind a stock buyback
A stock buyback enables the company to invest in itself. When a company buys back its stocks it actually reduces the number of shares outstanding on the market. But at the same time, this increases the proportion of shares held by investors. A stock buyback is a business action. For example, the company sees its stock is undervalued, so it makes a buyback. This action is usually aimed to provide investors with a return. Such a company is bullish on its operations at that time, and stock buyback can significantly increase the earnings gained from shares allocation. The point is that the stock price will rise only if the P/E ratio is sustained. Also, when the company reduces the number of shares outstanding, it makes them worthier. That is the way to increase the stock’s EPS, stock price, and decrease the P/E ratio.
A stock buyback shows to investors that the company has enough cash deposited aside for unpredictable difficulties and a low chance of financial problems.
Also, a company can do that for the purpose of compensation when it wants to award employees or management with stock and stock options. That’s also the reason behind stock buyback, to avoid the dilution of existing stockholders.
How stock buyback is carried out?
The company may present to its shareholders a tender offer. Shareholders have an opportunity to tender all their shares or part, a portion of them. The company limits the time for that. The price of a stock is at a premium price or the current market price. The premium price is compensation for stockholders that are willing more to offer their stocks, rather than hold them.
The company may buyback stocks on the open market, also. Some have buyback programs and from time to time you can see their offers. The share buybacks have a stimulative effect. Companies have more cash on hand to pay their debts or to provide cash for further operations. Also, some companies can extend share buybacks, which leads to a faster reduction of their shares float. Increasing the company’s important financial ratios also can be one of the reasons as much as undervaluation or ownership consolidation. For example, large, expanded buybacks may affect the share price to go up.
Generally speaking, buybacks are a sign of a company’s capacity to return value to its shareholders. One historical data is interesting. The companies that practice regular buybacks have outperformed the wide market.
The influence on investors
To the investors that own stock in the company that is doing buybacks, the stock buyback will boost the value per share. This action will give them more money and fast. But to really have any benefit from the company’s stock buyback you must hold enough stock. Otherwise, the buyback will not affect you significantly. To be honest, the greatest portion of the stock holds a small group of investors and they will have greater benefits from this gain.
That’s true, but also the truth is that the wealthiest 10% of investors hold 80% while almost 80% of shareholders hold just little as 8% of all stock shares.
A stock buyback isn’t cheap. Companies are spending a lot of money to exercise the buybacks. Some investors think that using extra cash for buying their shares in the open market is quite in contrast to what the companies have to do. They think they should reinvest that extra cash to support growth, to develop the company and provide more jobs or to expand the existing capacity.
Moreover, some investors claim that stock buybacks are synthetically pushing the per-share price higher. Also, they argue that this move is beneficial for management only. It isn’t secret that management’s capital is connected to stock ownership in their company.
The conclusion is – the stock buyback can drive the per-share price higher and the stock may look more attractive. The company will have the same earnings but the number of shares outstanding will be reduced.
Lately, companies like this practice, since the stock buyback is one way more to return value to shareholders. The others are dividends.
Buybacks vs dividends?
Both offers are all about how to return funds to investors. But which of these two programs investors like more? In case the financial markets are ideal, in the meaning of perfection, it shouldn’t matter.
For example, ABC company has one million shares in issue and excess cash of $2 million which it wants to distribute to investors. After this distribution, this ABC company expects profits of $1 million yearly and also expects a P/E ratio to be 8 times. So, this company can distribute this $2 million as a dividend of $2 per share or as a tender offer of 200,000 shares at $10 per share.
No matter which distribution they choose the total market value will be the same. Whichever method they choose the risks will be the same. But let’s do some math. So, we have to multiply the total market value by the P/E ratio.
In our example, it is:
total market value = $1 million x 8 = $8 million
But what we have here is if the company prefers to pay dividends, there will be a million shares in issue. Under the buyback, there will be 800,000 shares in issue. So, the value per share will be $8 (simple math: $8million/1 million) under the dividend option and $10 ($8 million/800,000) under the buyback option.
Let’s examine a case of a shareholder that holds 5.000 shares in both the dividend and the buyback situation. Such has a choice to hold or sell the shares.
As you can see this is the same for investors. Under both dividend and buyback options, shareholder’s wealth remains the same.
For dividend options, the shareholder has 5.000 shares worth $8 each plus $2 dividend per share. Which makes $50.000. While under the stock buyback option a shareholder will receive $10 per share, which is $50.000 also. Thus, for a shareholder both options are equally beneficial.
The above case is accurate only if the financial markets are perfect. But in the real world, they are not. So, shareholders may prefer buybacks.
