Share Buyback

Quick Summary of Share Buyback

A share buyback occurs when a company repurchases some of its own stock either through purchasing shares on the open market or by buying shares directly from shareholders through a tender offer at a premium to current market price.

The purchase by a listed company of its own shares either in the open market or by tender offers.

Share buybacks (or simply “buybacks”) are typically considered a positive development by investors. A buyback can indicate that the company believes itself to be undervalued. However, if the company happens to be incorrect about its own prospects, then the company has actually done a disservice to its investors.

Companies do it for five reasons:

1. to increase the share price – according to the normal laws of supply and demand, the entry into the market of a buyer, in this case, the company itself, has a tendency to push up prices
2. to rationalise the capital structure – the company believes it can sustain a higher debt-equity ratio
3. to substitute dividend payouts with share repurchases, because capital gains may be taxed at a lower rate than dividend income
4. to prevent the dilution of earnings caused, for example, by the issue of new shares to meet the exercise of stock option grants
5. to deploy excess cash flow and return it to shareholders

The share buyback may increase the share price of a company by reducing the supply of shares available for purchase. The investor can benefit from this in two ways: (1) The stock price of said company may go up; (2) The investor’s percentage share of the company’s earnings is now perceived to be greater by other investors using common investor metrics such as P/E ratios.

Some investors prefer buybacks to dividends, as the shareholder does not have to pay a dividend tax. Proponents of share buybacks contend that they represent a more efficient means of returning earnings to shareholders than dividends.

A company may also buy its shares back to help fend off hostile takeover bids. By reducing the number of shares available and driving up the share price, the company using a buyback strategy makes it more difficult for an investor to gain a controlling stake in the company.

Do note, however, that when a company announces a buyback, that does not automatically mean that the company will actually spend all that money. The actual purchasing is at the discretion of management.

Sometimes investment markets look with favour on companies that indulge in buybacks. Sometimes it is seen as a sign that the company’s directors have run out of ideas. It all depends on the circumstances of the company concerned.

The reverse situation of the share buyback is called dilution.

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