In practice, there are many companies that choose to buy back shares as their primary (and only) approach to returning profits to investors. One question that might arise is why exactly companies decide to repurchase their own shares when they could just pay out dividends to their shareholders directly instead? In the following, we will discuss three valid reasons why companies buy back shares.
What Is a Share Buyback?
A share buyback is the act of a company to repurchase shares from the firm’s shareholders. Share buybacks effectively reduce the number of outstanding shares and increase the proportional ownership of each existing share.
Share buybacks are known as one of the two primary ways for companies to return profits back to shareholders as an alternative to paying out dividends. One way to think of a share buyback is a transfer of value within a company: Investors who are willing to tender their shares to the company are giving up their value to cash out, while all the remaining shareholders benefit from an ownership increase for each of their shares.
Why Do Companies Buy Back Shares?
There can be several different intentions behind every share buyback that a business chooses to conduct:
- Share buybacks give companies the opportunity to directly address the interests of those shareholders that want to profit from their shares while at the same time benefitting existing shareholders.
- The consequences of a share buyback can also boost and enhance important financial metrics.
- Buying back shares enables firms to take advantage of undervaluation.
1. Complementing Different Interest Groups
First of all, let’s directly compare share buybacks with the act of paying out dividends as options for a company to return profits back to shareholders.
When a company decides to pay out dividends, it essentially distributes a certain amount of cash to all existing shareholders, meaning to those who do want to take profits out of the business to use it for individual purposes but also to the shareholders who actually don’t need the cash and would rather prefer the excess profits to stay within the business.
Share buybacks are in this regard a different matter because when companies buy back shares from the marketplace, only the shareholders who are willing to sell their existing shares to the company will be directly addressed, and shareholders who don’t want to sell will benefit from increasing interest in the business.
So one of the main reasons why many companies don’t just strictly pay out dividends to shareholders is because there are simply many different interest groups of shareholders within a company.
Some prefer to make a quick return of the stock and thus prefer to invest in the company for the short-term, while others actually want to stay within the business for years to come and be part of further long-term growth.
As a result, businesses can serve the interests of shareholders in a better way by utilizing a balance between share buybacks and dividend payments.
2. Enhancing Financial Metrics
A more obvious outcome of share buybacks is the fact that each buyback directly affects the proportional value of every single share positively as a consequence of a lower total share count after the buyback.
Shareholders who haven’t sold their shares in the first place will benefit from a stock buyback because of their increase in ownership within the company that can come in more handy if they decide to stay with the business for the long-term.
Important financial metrics such as the earnings-per-share (EPS) will also increase as soon as a company buys back its own shares. A higher EPS might encourage more investors to buy into the company and thus lead to a higher demand that gets reflected on the stock price shortly after the stock buyback has happened.
Let’s assume that company ABC is currently broken up into 10,000 shares outstanding while the stock is trading at $90 per share. The business is doing quite well and has generated $60,000 in net income for its shareholders in the last year. If we divide the net income by the total number of shares, we would come up with an earnings-per-share of $6 for the company.
Now let’s say that the business decides to repurchase 2500 shares from the marketplace, which reduces the total number of shares down to 7500.
Suddenly, the EPS would increase from $6 to $8 without the business actually generating more profits. A higher EPS would likewise make the P/E for the stock look more attractive. Before the share buyback, the P/E for company ABC was 15 (dividing 90 by 6) but after the share buyback, the earnings multiple is now at 11,25 which is considerably lower than before. In order for the P/E ratio to stay unchanged, the price of the stock would need to increase consequently.
»Learn more about the P/E ratio
The same also goes for performance metrics such as the return on equity that will look better than previously when a company buys back its own shares.
In the above, we’ve looked at how stock buybacks can impact the income statement by having a look at the EPS but because companies obviously need to use their cash reserves to fund the share buyback, the balance sheet doesn’t appear unaffected as well.
When a stock buyback occurs, the assets of the business decreases while the shareholder’s equity drops correspondingly. Since the formula for an accounting measure like ROE goes as:
The numerator (shareholder’s equity) decreases, which leads metrics like ROE, ROA, and ROIC to increase. That could in return make company to look more attractive in the eye of investors and thus drive demand and popularity for the stock.
3. Taking Advantage of Undervaluation
A share buyback can also be beneficial for a company and its shareholders in the long-run when the company manages to buy back its own shares at a lower price than what the company is truly worth.
So why should companies only buy back shares at a reasonable price?
It’s the exact same reason why value investors only invest in companies that they consider undervalued. It simply doesn’t make rational sense to buy investments at a overvalued price, considering that the price at which you acquire a stock directly affects the return which you get from that investment.
»Learn more about whether a stock is undervalued or overvalued.
The principles of value shouldn’t be any different for companies that have to decide whether they buy their own shares at a certain price or not. Since we know that in a share buyback, only the shares from shareholders who are actually willing to tender their shares will be bought by the business, the existing shareholders will essentially benefit from being able to acquire more ownership of undervalued shares.
Additionally, because investors generally assume that the management of a company should know what they’re doing, stock buybacks often arouse positive reactions among investors as this would indicate that the company believes that shares are currently trading at an undervalued price.
However, in practice, it is one thing for the management of the company to assess when the company’s stock is undervalued but another thing to actually conduct stock buybacks when the price is right and to have and utilize the excess cash to fund the buyback.
Especially in bull markets, many companies tend to continue to buy back their own shares even for overvalued prices since that is usually the time when businesses are in enough financial abundance to afford stock buybacks in the first place.
Oftentimes, companies don’t even fund a share buyback from their excess cash but also from raised debt just to raise investor’s confidence and push stock prices even further, which can have a negative impact to the long-term prospects in certain cases.
While there can be several other reasons why companies might decide to repurchase shares, the primary intentions of companies should simply be to distribute excess capital the shareholders while benefiting long-term investors and to take advantage of an undervalued stock whenever a business comes across the opportunity to do so.
As an investor, it is always a good idea to follow a company closely whenever it is choosing to repurchase shares. The goal should then be to assess whether the decision to buy back stock is justified by valid reasons and long-term intentions or not.