US companies in the S&P 500 have spent over U$135 billion on share buybacks during the fourth quarter of 2015, representing a 5.2% rise year-on-year. Consumer technology giant Apple Inc. (NASDAQ: AAPL) topped the list, spending U$6 billion on repurchasing its own stock. Share buybacks are very common in Australia too. Local pharmaceutical company CSL Limited (ASX: CSL) announced a share buyback program of $1 billion in October 2015. The number of buybacks has risen substantially since the GFC and some investors may be confused and wonder what the purpose of a buyback is, why companies buy their own stock, what the impact on the share price is and how shareholders benefit from a buyback.
What is a Share Buyback?
As the name suggests, a share-buyback or a share repurchase refers to the process when a company re-acquires its own stock or, in other words, the company buys shares back from its shareholders. in Australia, the Australian Securities & Investments Commission (‘ASIC’) as well as the Corporations Act 2001, layout a number of rules and regulations for buybacks.
Why Companies Consider Share Buybacks
With an increasing number of companies announcing buybacks, it appears that directors believe that buybacks have a positive impact on the business as well as shareholders. Listed below are some of the most common reasons why a company might repurchase its own shares:
Take Advantage of Undervalued Share Price:
A common scenario for a share repurchase is when management believes that their own shares are ‘undervalued’. Rather than keeping surplus cash in the bank, management decides to purchase shares of the company at – what they believe – a ‘cheap’ price. The buyback has two effects on the company’s stock: On the one hand, the number of shares outstanding is being reduced (we will go more into detail below) and buying pressure increases as the company is physically buying its own stock. On the other hand, by buying (often) millions of dollars of its own stock, management also reassures the market that they are confident in their own business operations, which encourages investors to buy. The market thinks that management would only buy their own stock if they believe that the value per share will increase in the medium to long-term.
Reduce Dilution and Increase Ownership:
Over time companies tend to issue new shares, e.g. via capital raisings or exercise of options, which implies dilution of existing shareholders. By buying back stock, a company can reduce the impacts of dilution. Also reducing the number of shares outstanding may help increase ownership of the company’s management.
Enhancing Financial Ratios:
While enhancing a company’s ratios might not be the sole reason for repurchasing shares, it is often an attractive by-product of these transactions.
Reducing the number of shares outstanding can have a positive impact on various ratios that are tracked closely by the market.
Return on Asset (ROA): This ratio is calculated by dividing a company’s net income by total assets. Reducing the share capital reduces a company’s total assets and overall has a positive impact on the ROA.
Return on Equity (ROE): Return on Equity is expressed as the amount of net income returned as a percentage of shareholders’ equity. Hence, if a company’s earnings remain constant, reducing the total equity lifts its ROE.
Earnings Per Share (EPS): This ratio is calculated by (net income – dividends on preferred stock)/ average outstanding shares. Hence reducing the overall outstanding shares boosts the EPS of a company.
How do Shareholders benefit from a Buyback?
A share-buyback is a capital management strategy that is often seen as a benefit or reward to shareholders. While investors clearly benefit from dividends, as money is deposited directly into the shareholder’s bank account, the benefits of buybacks are indirect. As we can see from the aforementioned factors, lowering the number of shares outstanding ultimately helps to increase the share price. The company returns cashback to its shareholders and also gives investors the opportunity to capitalise on their investment. Management shows confidence in their own company which may enhance market sentiment towards the stock.
There is obviously no guarantee that the buyback will result in net capital gains as the price of a company’s stock depends on a variety of factors. However, buybacks are often considered an attractive way to invest surplus cash whilst boosting investor confidence.
When are Buybacks Not in the Best Interest of Shareholders?
While buybacks might be a sensible way for companies to use extra cash, however, in some cases, a buyback might not be in the best interest of shareholders. Listed below are a few scenarios when a share repurchase might hurt shareholders.
If a share repurchase is made when the company’s shares are already overvalued, management is not making the best use of the company’s cash. According to Factset, Apple paid a 13% premium to buy back its shares during the fourth quarter. Buying back stock ‘for the sake of it’ may have an adverse impact.
In some cases, when borrowed money is used to buyback stock, it can hurt the company’s ratings. Borrowing money for the purpose of share repurchases might drain a company’s cash reserves, which could otherwise be used during tough times.
Using surplus cash for purchasing its own shares might also indicate that the company’s management has no better option to invest surplus cash and the market may be disappointed as there are better opportunities elsewhere.
Share buybacks can be an efficient way for management to boost the company’s undervalued share price and reduce dilution, but they also allow management to show confidence in their business operations. However, as briefly outlined above, not every buyback automatically benefits shareholders. Hence it is important for investors to gauge the timing and purpose of a buyback and also look at the overall financial situation of the company.