This article written by Akshit Gupta (ESSEC Business School, Master in Management, 2019-2022) presents an introduction of a Share buyback .
Share buyback or share repurchase refers to a financial transaction where a company buys a part of its outstanding shares that it issued earlier in the market. The repurchase of shares reduces the outstanding share capital of the company and increases the ownership rights of the continuing shareholders. The shareholders who are willing to subscribe to the share buyback program are paid in cash and lose their ownership in the company to the extent of their shares sold back. The shares bought back by the company are either held by it for issuance on a future date or cancelled depending on the company’s decision.
Share buyback programs are either funded using the cash of the company or by taking additional debt to fund the buyback program. Generally, if a company takes a debt to fund the share buyback programs, it sends a mixed signal (positive as well as negative, depending on how the market participant is affected by such a program) to the market participants as the company takes on more debt. The credit rating agencies also tend to downgrade the respective company’s ratings due to the increase in debt.
Share buyback mechanism
When a company executes a stock buyback program, the transaction reduces the company’s number of shares outstanding in the market. The transaction can be carried out using several methods, some of which are:
- Buyback from open market
Under such a mechanism, the company informs its brokers to systematically buy the shares from the open market at the currently prevailing market price. The action generally leads to an increase in the market price of the shares due to the increase in demand for the share and positive investor outlook for the buyback. Also, a company buying back shares from open market doesn’t have any legal limitations in terms of the buyback program, which means the company can suspend or cancel the program at any given point.
- Tender offer
Another way a company can execute stock buyback program is through issuance of tender offers to the investors. The company can either issue a fixed price tender offer or a Dutch style tender offer (such offers generally have a price range and the investors have the power to decide the ideal buyback price). The company provides a fixed window to complete the buyback program and such offers are generally carried out at a premium on top of the stock’s market price.
Reasons for a share buyback program
A company can execute a share buyback program for several reasons:
- Undervalued stock price – If the company’s management think that the company’s share prices in the market are undervalued, they can go for a share buyback program to decrease the number of outstanding shares in the market and increase the share prices. If the share prices increase on a later date, the company can also re-issue the bought back shares at a better market price.
- Availability of debt at lower cost – The cost of equity for a company generally exceeds the cost of debt. If a company has availability of debt at lower rates, they can buy back shares from the market by taking additional debt to support the funding.
- Control dilution of ownership – Whenever a company wants to control the dilution of their ownership, they resort to share buyback programs which reduces the number of outstanding shares in the market and also increases the shareholder value. The issue of Employee stock options (ESOP) is generally followed by a share buyback program which helps the company to reduce the dilution of ownership and voting rights.
- Improve financial statements and ratios – Share buyback programs improves the financial ratios for a company by improving the different financial statements for the company. Share buybacks help in reducing the number of outstanding shares of a company which increases the Earning Per Share (EPS). It leads to a higher Price/Earnings ratio without having an actual increase in the earnings.
- Tax benefits – In certain countries, the tax rates on dividends and capital gains differ with a high margin. A company can execute a share buyback program which benefit the investors who will have to pay lower taxes for the capital gains earned through share buybacks.
For example, in most of the countries the share buybacks are taxed at a short/long term capital gain tax rate and dividends are taxed at the income tax rate. If the income tax rate is 35% and long-term capital gain tax rate is 25% in a country, the shareholders benefit from share buy- back programs by paying less taxes if they own the shares for more than 1 year.
- Avoid hostile takeover attempts – The management of a company fearing a hostile takeover can also execute a share buyback program to reduce the number of outstanding shares in the market and protect themselves from takeover attempts in the marketplace. The shares are either held by the company in their treasuries for issuance in the future or cancelled by them.
Benefits of Stock buyback
The companies benefit from the share buy back in several ways which includes,
- Reduction in dilution of ownership by cancelling the shares bought-back.
- Share buy backs help the companies to improve their market price of shares by reducing the number of shares available in the open market.
- The companies can utilize the excess cash during period of slow growth to buy back the shares from the market.
- The companies can also benefit by selling the bought back shares at higher market prices (purchased at undervalued prices).
The shareholders entering share buyback programs can benefit in following ways,
- The shareholders benefits from the tax benefits on the income generated by selling the shares back to the company.
- The companies generally buy back shares at a premium over the prevailing market price. The shareholders also benefit from capital gains earned in the share buyback programs.
The shareholders who don’t prefer to enter the share buy-back programs also benefits from,
- Increase in market price of shares post share buybacks.
- Increase in shareholder value due to decrease in the dilution of ownership.
- Increase in ownership and voting rights.
Example of share buyback programs
- In September 2019, Microsoft announced a share buyback program worth $40 billion, giving a boost to the market prices of company’s shares and the investors also saw an increase in the dividends given by the company. The company has been using its cash resources to fund this share repurchase program.
- Alphabet (the parent company of Google) allocated more than $18 billion to fund the share repurchase program over 2019. The company has been using its cash resources to fund the buyback program. Although the company has been continuously buying back shares from the market, its number of shares outstanding in the market remains the same due to an increase in share-based compensation to its employees.
Market reaction after the announcement of a stock buyback program
The market reaction of share buyback programs is different for different market participant. But in general, the program sends a positive signal to the market as the share buyback programs show companies strong financial health and the top management’s belief in their strengths. A company undertaking share buyback generally believes their share prices are undervalued by the market. So, such a program sends a positive signal to the market regarding company’s optimism and trust in their market value.
But, if the share buyback programs are funded by taking additional debt, it can also be perceived negatively by certain market participants. Credit rating agencies and some investors have a negative outlook for companies that have higher debts. So, such a program can lead to negative sentiments about the company for some participants.
Investopedia article: Introduction to share buyback
Harvard business review article: “Is a Share Buyback Right for Your Company?” by Justin Pettit
The Balance article: Benefits of the stock buy-back programs
About the author
Article written by Akshit Gupta (ESSEC Business School, Master in Management, 2019-2022).