As a new investor, you may come across terms in news reports or public filings that you’re not familiar with and still don’t completely understand after looking it up. This article is part of DollarsAndSense’s investor education series, which introduces and explains investment-related terms.
Today, we answer the question: What are share buybacks?
Definition of ‘Share Buyback’
A share buyback, or repurchase, is a move by a listed company to buy its own shares. This can be from the open market, issuing a tender offer, or arranging for a private buyback from a shareholder(s). Share buybacks are a corporate action that require companies to make a public filing with regulators.
After a share buyback, companies can re-distribute the shares, re-designate the shares as treasury shares, or retire the shares.
Companies typically fund a share buyback using excess operating cashflow, using its cash reserves, or by taking on debt.
Why Do Companies Perform Share Buybacks?
There are many reasons why companies perform share buybacks, which are generally regarded as a positive signal of the future prospects of the company.
Management Believes Shares Are Undervalued
The fact that management is willing to pay a cash premium to do a share buyback sends a signal that they believe that the company’s shares are currently trading below what they are really worth. This could be due to rumours, scandals or failure to meet expected earnings predictions, all of which have nothing to do with the fundamental strength and future earnings potential of the company.
Increase Value Of Existing Shares
Because a buyback reduces the number of outstanding shares, each of the remaining shares represents a larger percentage of equity in the company. This is great news for everyone still vested in the company.
If the company pays out the same amount money to shareholders in dividends the following year, because the total number of shares is reduced, each shareholder receives a larger dividend. Of course, if the company chooses to keep the dividend percentage the same, then would be able to pay out less money in total.
Provide A Boost In Metrics
The mere reduction in outstanding shares would already improve the metrics measuring the company’s performance with regard to their stock price.
Even if the company’s earnings remain the same, the stock’s earnings per share (EPS) increases while their price-to-earnings ratio (P/E) decreases. A buyback also has a positive impact on a company’s return on equity (ROE), simply because returns are against a lower amount of equity.
These metrics are commonly used by investors to screen for potential stocks to buy, and having favourable ratios is seen as a strength.
Allow Shareholders To Divest At A Premium
A buyback offers shareholders the option to sell part or all of their shares and receive a cash payment at a premium to the current trading price. Sometimes, a large shareholder may be looking to divest their holdings, so the company performs a buyback and absorb the shares.
Another reason companies have a buyback programme is to reward their employees and management in the form of stocks and stock options, without diluting existing shareholders. Having employees and management own stocks also keep them vested in the continued success of the company.
Impact of Share Buybacks On A Company’s Stock
The resulting increase in metrics like earnings per share and the company’s conviction in their future prospects, are generally seen as positive developments by the market and would generally boost a company’s share price after a share buyback.
Some might argue that a share buyback simply bridges the the gap between what a company’s shares are currently selling for, and what it should be selling for, based on its intrinsic value.
Do Your Own Diligence
Because of the positive effects share buybacks have on a company and their stock, be wary of companies that execute share buybacks for the sole purpose of boosting their metrics or to enjoy renewed interest that comes from this corporate action.
If you decide that a company’s stock is not undervalued, but management is aggressively engaging in a share buybacks by taking on debt, then you really should be sceptical and wary.
So now that you understand share buybacks better, what is another investing term you want us to cover next? Let us know on the DollarsAndSense Facebook Page!
As a budding investor, how well do you know about the important asset class known as bonds? Watch this short video and see if your knowledge measures up:
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