What Is a Buyback?
A stock buyback is when a public company uses cash to buy shares of its own stock on the open market. A company may do this to return money to shareholders that it doesn't need to fund operations and other investments.
In a stock buyback, a company purchases shares of stock on the secondary market from any and all investors that want to sell. Shareholders are under no obligation to sell their stock back to the company, and a stock buyback doesn't target any specific group of holders—it's open to anybody.
Public companies that have decided to do a stock buyback typically announce that the board of directors has passed a “repurchase authorization,” which details how much money will be allocated to buy back shares—or alternatively the number of shares or percentage of shares outstanding it aims to buy back.
What is Share Buyback/Repurchase?
Share or stock buyback is the practice where companies decide to purchase their own share from their existing shareholders either through a tender offer or through an open market. In such a situation, the price of concerning shares is higher than the prevailing market price.
When companies decide to opt for the open market mechanism to repurchase shares, they can do so through the secondary market. On the other hand, those who choose the tender offer can avail the same by submitting or tendering a portion of their shares within a given period. Alternatively, it can be looked at as a means to reward existing shareholders other than offering timely dividends.
However, company owners may have several reasons for repurchasing their stocks. Individuals should make a point to find out the underlying causes to make the most of such decisions and also to benefit from them accordingly.
Buybacks are carried out in two ways:
- Shareholders might be presented with a tender offer, where they have the option to submit, or tender, all or a portion of their shares within a given time frame at a premium to the current market price. This premium compensates investors for tendering their shares rather than holding onto them.
- Companies buy back shares on the open market over an extended period of time and may even have an outlined share repurchase program that purchases shares at certain times or at regular intervals.
A company can fund its buyback by taking on debt, with cash on hand, or with its cash flow from operations.
An expanded share buyback is an increase in a company's existing share repurchase plan. An expanded share buyback accelerates a company's share repurchase plan and leads to a faster contraction of its share float. The market impact of an expanded share buyback depends on its magnitude. A large, expanded buyback is likely to cause the share price to rise.
The buyback ratio considers the buyback dollars spent over the past year, divided by its market capitalization at the beginning of the buyback period. The buyback ratio enables a comparison of the potential impact of repurchases across different companies. It is also a good indicator of a company's ability to return value to its shareholders since companies that engage in regular buybacks have historically outperformed the broad market.
Example of a Buyback
A company's stock price has underperformed its competitor's stock even though it has had a solid year financially. To reward investors and provide a return to them, the company announces a share buyback program to repurchase 10% of its outstanding shares at the current market price.
The company had $1 million in earnings and 1 million outstanding shares before the buyback, equating to earnings per share (EPS) of $1. Trading at a $20 per share stock price, its P/E ratio is 20. With all else being equal, 100,000 shares would be repurchased and the new EPS would be $1.11, or $1 million in earnings spread out over 900,000 shares. To keep the same P/E ratio of 20, shares would need to trade up 11% to $22.22.
Criticism of Buybacks
A share buyback can give investors the impression that the corporation does not have other profitable opportunities for growth, which is an issue for growth investors looking for revenue and profit increases. A corporation is not obligated to repurchase shares due to changes in the marketplace or economy.
Repurchasing shares puts a business in a precarious situation if the economy takes a downturn or the corporation faces financial issues it cannot cover. Others allege that sometimes buybacks are used to inflate share price artificially in the market, which can also lead to higher executive bonuses.
As part of the Inflation Reduction Act of 2022, certain stock buybacks for domestic public companies will incur a 1% excise tax, making them more expensive for corporations. This applies to buybacks after Dec. 31, 2022.12
Why Would Companies Do Buybacks?
A buyback allows companies to invest in themselves. If a company feels that its shares are undervalued then it may do a buyback to provide investors with a return. The share repurchase reduces the number of existing shares, making each worth a greater percentage of the corporation. Another reason for a buyback is for compensation purposes. Companies often award their employees and management with stock rewards and stock options and a buyback helps avoid the dilution of existing shareholders. Finally, a buyback can be a way to prevent other shareholders from taking a controlling stake.
How Is a Buyback Done?
A company can make a tender offer, at a premium over the current market price, to shareholders where they have the option to submit all or a portion of their shares within a given time frame. Alternatively, a company may have an outlined share repurchase program that purchases shares on the open market at certain times or at regular intervals over an extended period of time. A company can fund its buyback by taking on debt, with cash on hand, or with the cash flow from operations.
What Are Criticisms of Buybacks?
Criticisms of buybacks include creating a perception that a business does not have other pathways for revenue growth. Furthermore, if a company purchases back its share and the economy takes a downturn, this would negatively impact its financial standing. Buybacks are also often criticized for artificially inflating the share price, which can be used to justify higher executive bonuses. Critics also argue that the 1% excise tax on buybacks will have negative consequences on the financial world.
Advantages of share buyback
Share buybacks reduce the number of shares available in the market. They increase Earnings Per Share (EPS) on the remaining shares, benefiting shareholders. For companies loaded with cash, EPS helps as the average yield on corporate cash investments is barely more than 1%.
Also, when companies have excess cash, when they opt for buyback programs, the investors feel more assured. Investors feel more secured with the fact that the companies were using the money to reimburse shareholders rather than investing in alternative assets. This move in-turn supports the price of the stock.
When companies go for buybacks, they tend to reduce the assets on their balance sheets and increase their return on assets.
There are also tax benefits associated with buybacks. When excess cash is used to buy back company stock, shareholders have the opportunity to defer capital gains if share prices increase.
Whenever shares of a company trade at too low a level, it usually buys back shares. Companies could also leverage on buybacks when a recession hits the economy, a similar sort of crisis or in times of market correction.
Buyback increases share prices. Often a reduction in the number of shares in the market leads to a price increase. A stock trading is based a lot on supply and demand. Hence, a company can bring about an increase in its stock value by creating a supply shock through a share buyback.
Also, as we have mentioned earlier, companies tend to protect themselves from a hostile takeover by buybacks.
Disadvantages of share buyback
Share buybacks are often perceived to be ‘marketing gimmick.' Investors need to be wary of this and not get into its trap. As companies sometimes pursue buyback to boost share prices artificially. Executive compensations in a company are often tied to earnings metrics. If earnings cannot be increased, then buybacks can superficially boost earnings.
Also, buybacks can often get misleading. When buybacks are announced, any share purchase tends to benefit short-term investors rather than long-term ones. This creates a false notion in the market about improving earnings. A buyback ultimately ends up hurting the value.
Some companies buy back shares to raise funds for reinvestment. According to experts, this is all good until the money is injected back into the company. The share buybacks are often not used in ways to grow the company. In many cases, share buybacks outnumber funds spent on research and development (R&D).
Buybacks tend to reduce a company's cash reserves, thereby giving it less cushion in tough times. In the process, it makes its balance sheet look less healthy.