What It Is and Why Companies Do It
Share repurchase, also known as share buyback, is a corporate activity in which a company purchases its own shares from the market. This reduces the number of outstanding shares while increasing the value of the remaining shares. Share buybacks can provide numerous benefits to the company and its shareholders, including:
- Improving financial ratios: Share buyback can increase earnings per share (EPS) and return on equity (ROE) by reducing the denominator of these ratios. For example, if a company has 10 million shares outstanding and earns $10 million in net income, its EPS is $1. If it buys back 1 million shares, its EPS becomes $1.11 ($10 million / 9 million shares). Similarly, if a company has $100 million in equity and earns $10 million in net income, its ROE is 10%. If it buys back $10 million worth of shares, its ROE becomes 11.11% ($10 million / $90 million equity).
- Signaling undervaluation: Share buyback can indicate that the company believes its shares are undervalued and that it has confidence in its future prospects. By buying back shares at a lower price than their intrinsic value, the company can create value for its shareholders and increase its share price in the long run.
- Returning excess cash: Share buyback can be a way of returning excess cash to shareholders when the company does not have profitable investment opportunities or when it wants to maintain an optimal capital structure. By buying back shares, the company can reduce its cash balance and increase its debt-to-equity ratio, which may lower its cost of capital and enhance its profitability.
- Preventing hostile takeovers: Share buyback can also be a defensive strategy to prevent hostile takeovers by reducing the number of shares available for acquisition and increasing the ownership stake of existing shareholders. By buying back shares, the company can make itself less attractive to potential acquirers and increase its bargaining power in case of a takeover bid.
There are different methods of share buyback, such as:
- Open market share buyback: The company buys back its shares directly from the market through its brokers. This is the most common and flexible method of share buyback, as it allows the company to adjust the timing and amount of repurchases according to market conditions and its cash flow situation.
- Fixed-price tender offer: The company makes a tender offer to its shareholders to buy back a specified number of shares at a fixed price on a fixed date. This method gives shareholders the option to sell their shares at a premium to the market price, but it also exposes the company to the risk of overpaying for its shares if the market price falls below the offer price.
- Dutch auction tender offer: The company makes a tender offer to its shareholders to buy back a specified number of shares within a price range. The shareholders can choose how many shares they want to sell and at what price within that range. The company then determines the lowest price that will enable it to buy back the desired number of shares and pays that price to all shareholders who tendered at or below that price. This method allows the company to set a maximum price for its share buyback and lets the market determine the actual price.
- Direct negotiation: The company negotiates directly with a large shareholder or a group of shareholders to buy back their shares at an agreed price. This method can be faster and cheaper than other methods, but it may also raise concerns about fairness and transparency among other shareholders.
Share buyback is not always beneficial for the company and its shareholders. Some of the drawbacks of share buyback are:
- Reducing future growth potential: Share buyback can reduce the future growth potential of the company by decreasing its retained earnings and limiting its ability to invest in new projects or acquisitions. If the company buys back shares at a higher price than their intrinsic value, it may also destroy value for its shareholders and reduce its return on invested capital (ROIC).
- Increasing financial risk: Share buyback can increase the financial risk of the company by increasing its leverage and reducing its liquidity. If the company borrows money to finance its share buyback, it may increase its interest expense and default risk. If the company uses cash to finance its share buyback, it may reduce its cash reserves and limit its flexibility to cope with unexpected events or opportunities.
- Manipulating earnings: Share buyback can also be used to manipulate earnings by artificially boosting EPS and ROE without improving the underlying performance of the company. This can create a false impression of the company’s profitability and growth potential and mislead investors and analysts.
In conclusion, a share buyback is a corporate action that can have both positive and negative effects on the company and its shareholders. Share buybacks can increase the value of the remaining shares, signal confidence in the company’s future, return excess cash to shareholders, and prevent hostile takeovers. However, share buybacks can also reduce the future growth potential of the company, increase its financial risk, and manipulate its earnings. Therefore, investors should carefully evaluate the reasons and methods of share buybacks before making their investment decisions.
