Share buyback refers to the repurchase of the company’s own outstanding shares from the open market using the accumulated funds of the company to decrease the outstanding shares in the company’s balance sheet thereby raising the worth of remaining outstanding shares or to block the control of various shareholders on the company.

Share buyback has increasingly become common since around the start of the 21st century. It is nothing but a company buying its shares. It was also considered “abnormal” earlier than that because it seemed like the company is planning roll back its IPO, leaving no chance for the remaining shareholders to ever see the stock recover. But toward the end of the last century, the rise in the volume of share repurchases had started and continued until the early years of this century, after which it became a “normal” phenomenon.

For example, the total value of shares repurchased in the US in 1980 was $ 5 billion, while the same metric ballooned to $ 349 billion in 2005.

Apple-Stock-Repurchase-v1

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Source: Share Buyback (wallstreetmojo.com)

Share Buyback Examples

Colgate’s Board authorized Share buyback with the aggregate repurchase of $5 billion under the 2015 Share buyback program

Share

source: Colgate 10K

There is only a limited number of reasons for a company to buy back its shares. They are listed below:

#1 – Taking advantage of undervaluation of the shares by the market

Once the shares of a company are issuedShares Issued refers to the number of shares distributed by a company to its shareholders, who range from the general public and insiders to institutional investors. They are recorded as owners equity on the Companys balance sheet.read more into the primary market, they eventually move into the secondary market and keep floating there, changing hands from one investor to the other. It is the public that buys and sells the company’s shares in the secondary market.

Apple Repurchased $14 billion of its own shares in two weeks after reporting disappointing financial results. “It means that we are betting on Apple,” Mr. Cook said.

“We are really confident about what we are doing and what we plan to do. We are not just saying that. We are showing that with our actions.” Mr. Cook added.

Apple

Sometimes the undervaluation of the stock is so much that the company is ready to offer to pay a premium to the interested sellers over the market price. This type of buyback is also called fixed price tender offerA tender offer is a public proposal by an investor to all the current shareholders to purchase their shares. Such offers can be executed without the permission of the firm’s Board of Directors and the acquirer can coordinate with the shareholders for taking over the firm.read more (you will see this in the later section)

#2 – A tax-efficient cash distribution alternative to dividend pay-out

When a company disburses dividend, there are immediate and higher tax implications. Similarly, when the company distributes the cash by doing share buyback, the tax rate is not as much as in the case of dividends. So by buying back the shares, the company is anyway returning a portion of its earnings and cash generated. But the net shareholder value is ensured by share buyback because of lower tax implications. However, in some countries, including the US, the tax laws have now been modified. Resulting in the tax rate on capital gains from share buy-backs that have become equal to that on dividend distribution.

Here you can easily take India as an example, where taxes have tilted scales in favor of buybacks compared to dividends

Also, see how the management can look at reducing the number of outstanding shares using the Treasury Stock MethodTreasury Stock Method is an accounting approach assuming that the options & stock warrants are exercised at the beginning of the year (or date of issue, if later) & proceeds from the exercise of these options & warrants are used to repurchase shares in the market. read more.

As noted by Amigobulls, IBM shares repurchase to achieve the EPS target set by the company. The management wanted to achieve a target EPS of $20 by 2015. Therefore they resorted to a robust buyback program, which in turn is leading to an increase in EPS.

#4 – Boosting the stock price

Simple supply-demand dynamics come into play here. As the company repurchases its shares, the supply of shares in the market gets reduced without affecting the demand. Hence, the share price is likely to increase as a result of reduced supply.

#5 – Maintaining the dividend pay-out ratio despite having excess cash

  • Paying regular dividends is vital for a company, at least in the eyes of its shareholders. And logically, the dividend must be proportional to the free cash generated before dividend distribution. However, the cash generated before dividend distribution cannot be ever-increasing and can’t even remain constant during each period after which dividend is distributed. It fluctuates.
  • Hence, dividend can’t be kept proportional to the cash generated. Instead of that, it is preferable to pay a constant dividend. Otherwise, when more cash is generated, the dividend increases. But when the cash generated decreases, the dividend also needs to be decreased.
  • A decrease in dividends might just send a wrong signal into the market. That is why maintaining a near-constant dividend pay-out ratio and that too a regular dividend pay-out is advisable.
  • Due to the above reasons, companies don’t generally increase the dividend too much. It is even when they generate a vast amount of cash compared to the previous reported periodA reporting period is a month, quarter, or year during which an organizations financial statements are prepared for external use uniformly across a period of time in order for the general public and users to interpret and evaluate the financial statements.read more. Still, to ensure higher returns to shareholders due to higher cash generation, the company’s management often decides to pay a part of the excess cash to the shareholders by offering to do share repurchase.
  • In this way, the company avoids the possibility of fluctuating dividends while still returning a higher amount of cash generated to the owners as and when possible.

#6 – Avoiding excessive cash accumulation and potential takeover

  • Having excess cash with no plans for investment in the foreseeable future does no good for a company. What is the harm in having too much excess cash? Companies with strong cash generation and limited CAPEX requirementsCapex or Capital Expenditure is the expense of the companys total purchases of assets during a given period determined by adding the net increase in factory, property, equipment, and depreciation expense during a fiscal year.read more do accumulate cash on the balance sheet.
  • This accumulation of excess cash makes the company a more attractive target for a potential takeover. Why so? Because even if the other company, interested in taking over the target company, doesn’t have the means to finance the takeover, it might as well finance it with debt and later use the cash accumulated on the balance sheet in order to pay down the debt incurred to carry out the acquisition.
  • It is this threat that companies often try to avoid by using up the excess cash for share repurchase and maintaining a lean cash position. The share buyback also avoids a takeover in one more way.
  • It boosts the stock price, as discussed in one of the above sections. By doing so, it makes the takeover itself more expensive. Therefore, a share repurchase is also used by companies as a part of their anti-takeover strategy.

For example, as noted by Amigobulls, In Mid-2007, buyout firms were going aggressive and leaving no opportunity to efficient buyout firms.  As a reaction to this, Expedia authorized a share buyback in June of 2007 to protect itself against a buyoutA buyout is a process of acquiring a controlling interest in a company, either via out-and-out purchase or through the purchase of controlling equity interest. The underlying principle is that the acquirer believes that the target company’s assets are undervalued.read more. Its outstanding shares figures of FY 2007 and FY 2012 reveals that the outstanding shares have decreased by 183.82 million shares or a reduction of 56% in several outstanding shares.

Suppose there are 10 million shares of the company outstanding in the market, and the stock price before buyback is $ 10.0. At this price, the company buys back 1 million shares leaving only 9 million shares in the market. Since the initial stock price was $ 10.0, the company would have used up $ 10 million for the buyback. So if the company initially had $ 50 million on its balance sheet, it would have only $ 40 million after the buyback. Assuming there is no change in any other asset, the total assets will also come down by the same amount, i.e., $ 10 million. The total earnings won’t be affected by the buyback. So assume no change in earnings.

The following table shows how various important parameters change when a share buyback operation is carried out:

Before BuybackAfter Buyback
Stock Price$10.0$10.5
Cash$5,00,00,000$4,00,00,000
Total Assets$10,00,00,000$9,00,00,000
Earnings$40,00,000$40,00,000
Shared Outstanding1,00,00,00090,00,000
Equity Outstanding$10,00,00,000$9,45,00,000
EPS$0.40$0.44
P/E2523.625
ROA4.00%4.44%
ROE4.00%4.23%

There are generally three common methods adopted by companies for doing share repurchases.

Open Market Share buyback

  • The most common of those methods is the “open market repurchase.” Almost 75 % of all share repurchases in the US are done using this method. When doing it by this method, the company makes a public announcement that it will be buying back its shares over a period of time from the open market from time to time as market conditions dictate.
  • The share buyback program doesn’t end with a single transaction. According to the prevailing market conditions from time to time, the company decides upon the feasibility, the timing and the volume of shares to be repurchased through each transaction. That is why open market repurchases often take months or even years to get completed.
  • Although the decision of the repurchase volume is in the hands of the company, there exist certain daily buy-back limits that restrict the amount of stock that can be bought over a particular time interval again, ranging from months to even years. For example, in the US, the SEC Rule 10b-18 dictates that the issuer can’t repurchase more than 25 % of the average daily volume.
  • Since the volumes involved in this repurchase method are huge, it greatly adds to the long-term demand for shares in the market and is also likely to affect the stock price till the time the repurchase operations continue.

An example is Celgene’s shares repurchased as “Open Market Repurchase.”

Open

source: CNBC

Fixed Price Tender Share buyback

  • A less common share repurchase method used by companies is the “fixed price tender.” In fixed price tender, the purchase price, the volume of shares repurchase, and the duration of the offer are pre-decided and pre-specified by the company.
  • And all this information is also made public through a mandatory public disclosure. The shareholder’s interested in selling their shares at the specified price express their interest.
  • Then the total number of shares offered by all the interested shareholders is compared with the number of shares the company wanted to buy. If the former number is higher, the company buys equal to the latter number from the selected shareholders.
  • But if the former number is lower, the duration of the offer is extended for more shareholders to express their interest.

An example is that of Schindler Holding Ltd’s plan to do share repurchase as a “Fixed Price Share Repurchase Offer.”

Fixed

Dutch Auction – Share buyback

Example: Expedia planned to do share repurchase of up to $3.5 billion of Stock in the Dutch Auction

Expedia

source: Payout Yield

Share Repurchase Video

Conclusion

There are a limited number of reasons why companies do share repurchase. They do it for the benefits that they can reap out of that activity. And in doing so, they also lure the shareholders into selling the shares to take some advantages like tax benefits.

However, it is in favor of investors to stay watchful of misguiding buybacks. They should understand the meaning of it in the context of the situation in which a company announces a buyback.

Recommended Articles

This has been a guide to what is Share Buyback and its definition. Here we discuss the top 3 methods of share repurchase along with examples and reasons. You may learn more from the following articles –

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