Everything you need to know about Stock Buybacks

In a stock buyback, the issuing business returns the portion of its ownership that was previously split between public and private investors while paying shareholders the market price per share.

 

When a corporation repurchases its shares, it has two options: it can buy the stock directly from its owners or on the open market. Dividends are no longer the favoured method for returning money to shareholders in recent years; share buybacks have taken their place. Blue-chip corporations are significantly more likely to exercise buybacks due to the costs involved, however smaller companies may decide to do so.

 

What Is a Stock Buyback?

 

When a publicly traded firm uses funds to buy shares of its own stock on the open market, this is known as a stock buyback. A business might take this action to give shareholders money they don't need to pay for operations and other investments back.

 

A corporation that conducts a stock buyback buys shares of stock on the secondary market from any and all shareholders looking to sell. A stock buyback is open to all stockholders and is not intended to target any particular class of stockholders. Shareholders are not required to sell their stock back to the firm.

 

A "repurchase authorization," which specifies how much money will be set aside to buy back shares or alternatively, the number of shares or percentage of outstanding shares it intends to buy back is typically announced by public companies that have decided to conduct a stock buyback.

 

Motives for Stock Buybacks

 

It may seem counter-intuitive that a company would decide to return the money given that it raises equity capital by selling regular and preferred shares. However, there are a number of circumstances in which a firm may benefit from repurchasing its shares, including lowering the cost of capital, consolidating ownership, maintaining stock prices, undervaluation, and enhancing its important financial ratios. 

 

1. Repurchases of Stock Lower Costs

 

A tiny ownership interest in the issuing firm, including the opportunity to vote on financial and corporate policy decisions, is represented by each share of common stock. A company truly has 1,000,001 owners if it has a managing owner and 1,000,000 shareholders. Companies issue shares to raise equity capital to fund expansion, but holding on to all that unused equity cash implies sharing ownership without a solid rationale if there are no possible growth chances.

 

2. Stock repurchases Keep the Stock Price Up

 

Typically, shareholders expect the corporation to pay them increasing dividends on a regular basis. The maximization of shareholder wealth is another objective shared by business executives. However, if the economy enters a recession, firm executives must strike a balance between pleasing shareholders and remaining agile. 

 

Why do some people prefer dividends over buybacks? A corporation can be required to reduce its dividends in order to retain cash if the economy weakens or enters a recession.7 The outcome would surely result in a stock sell-off. However, the stock price would probably suffer less if the bank chose to buy back fewer shares, achieving the same capital preservation as a dividend cut.

 

A company's price will surely rise if it commits to paying out dividends with consistent growth, but the dividend plan has potential drawbacks as well. Dividends cannot easily be reduced during a recession, while share buybacks may, with much less harm to the stock price.

 

3. The Share Price Is Too Low

 

Businesses that do buybacks frequently do so because they firmly believe that the value of their shares is undervalued. Undervaluation can happen for a number of reasons, but it frequently happens as a result of investors' limited capacity to look beyond a company's immediate results, dramatic news stories, or a generalized negative outlook. For instance, as the economy was emerging from the Great Recession in 2010 and 2011, a wave of stock buybacks swept the country.

 

Many businesses started issuing upbeat predictions for the future, but their stock prices continued to reflect the economic gloom that had dodged them in previous years. By repurchasing shares, these corporations made an investment in themselves in the hopes of profiting when share prices at last started to reflect new, more favorable economic realities.

 

In the event that a stock is significantly undervalued, the issuing firm may choose to repurchase part of its shares at the lower price and then reissue them once the market has recovered, boosting its equity capital without issuing any additional shares. However, if investors feel they have been taken advantage of by a corporation in this way, they can be hesitant to buy the re-issued shares.

 

Consider a scenario where a business issues 100,000 shares at $25 each, generating $2.5 million in equity. An unfortunate news story that casts doubt on the company's leadership ethics prompts terrified shareholders to start selling, bringing the share price down to $15. The business chooses to spend $750,000 to repurchase 50,000 shares at $15 each while waiting out the hysteria.

 

The company continues to be profitable, and the following quarter it introduces a brand-new, intriguing product line, pushing the price over the initial selling price to $35 per share. The corporation reissues the 50,000 shares at the new market price after regaining popularity, bringing in a total of $1.75 million in new capital. Due to the short-lived undervaluation of its stock, the corporation was able to increase its equity from $2.5 million to $3.5 million ($2.5 million - $750,000 = $1.75 million + $1.75 million = $3.5 million) without further diluting ownership.

 

4. Adjusting the Financial Statements

 

Another simple strategy to improve a company's appeal to investors is to buy back stock. A company's profits per share (EPS) ratio will naturally rise when the number of outstanding shares is decreased because the annual earnings are now split by a smaller number of existing shares.

 

For instance, a corporation with 100,000 outstanding shares and annual revenue of $10 million has an EPS of $100. In contrast, if it buys back 10,000 of those shares, bringing its number of outstanding shares down to 90,000, its EPS rises to $111.11 without an increase in earnings.

 

Additionally, prior to a planned buyback, short-term investors frequently attempt to profit quickly by making an investment in a company. The sudden flood of investors raises the company's price-to-earnings ratio (P/E) and unfairly inflates the stock's valuation. Another significant financial statistic that benefits is the return on equity (ROE) ratio.

 

A repurchase might be seen as a sign that the company is solvent and no longer requires more equity financing. The market may also conclude that management has sufficient faith in the business to make more investments in it. Share repurchases are typically viewed as less hazardous than investing in R&D for new technologies or purchasing a competitor; they are a profitable move as long as the business keeps expanding. Additionally, share buybacks are often viewed by investors as a sign that shares will increase in value in the future. Share buybacks may consequently result in a spike in stock purchases from investors.  

 

Also Read: The Effect Of The Pandemic On Financial Forecasting And Risk Management

 

How a Company's Value Is Affected by Stock Buybacks?

 

Stock buybacks can have a significant influence on the key measures investors use to assess a public business since they take cash out of the balance sheet of a firm and may reduce the number of shares outstanding.

 

It's crucial to realize that after a corporation buys back its own shares, the shares are either canceled, lowering the total number of outstanding shares permanently, or kept by the firm as treasury shares. These are not included in the calculation of shares outstanding, which has an impact on numerous crucial indicators of a company's financial health.

 

By dividing a company's net profit by the total number of outstanding shares, important indicators like earnings per share (EPS) are determined. 

 

The Drawbacks of Stock Buyback

 

Many detractors of stock buybacks claim that they are an inadequate strategy for businesses to increase value for their shareholders. The following are some drawbacks of stock buybacks:

 

• A waste of money: Stock buybacks may prioritize immediate share price increases when other, more profitable uses of the money are available, depending on a variety of reasons. While hoarding funds for emergencies or investing in R&D may not assist share prices in the short term, they may provide higher value in the long run.
   

• Debt-driven share repurchases: In the years prior to the Covid-19 epidemic, borrowing was used to fund up to 50% of all buybacks. Companies were encouraged to borrow money to use for share buybacks in order to boost short-term stock values because to low borrowing rates. Many detractors claim that this was a particularly naive tactic.
   

• Companies with lots of cash typically have high stock values: Some businesses that engage in stock buybacks have amassed a war chest of cash following a successful time. Companies in this situation also frequently have relatively high share prices, which suggests that they might not be providing shareholders with as much value as other ways to put the money.
   

• Used to obfuscate executive stock compensation: Many publicly traded corporations give shares as compensation to managers, diluting the value of other owners. Buybacks may be used by executives to conceal how this form of pay affects the number of shares in the company.

 

Effect of Stock Repurchases on the Economy

 

In spite of the aforementioned, buybacks might benefit a corporation. What about the economy overall? Stock repurchases may have a somewhat favorable impact on the national economy. Since they result in higher stock values, they frequently have a considerably more significant, beneficial impact on the financial markets.

 

However, the actual economy and the stock market are mutually reinforcing in many ways. For instance, studies have demonstrated that the "wealth effect," a phenomena where increases in the stock market have a beneficial impact on consumer confidence, consumption, and significant purchases.

 

Reduced borrowing rates for firms is another way that advances in the financial markets have an impact on the actual economy. These businesses are then more inclined to invest in R&D or expand their operations. These actions boost hiring and revenue, which in turn helps the household balance sheet to improve. Additionally, they raise the likelihood that customers will be able to borrow more money to start a business or buy a property.

 

Is Share Repurchase a Good Idea?

 

If a company doesn't need to fund expansions or other projects or wants to control the share price in the market, it may benefit from a share repurchase. Repurchases could or could not be advantageous to investors, depending on their objectives and financial situation. However, investors can buy back shares at a cheaper price if a firm repurchases them and then issues them at a lower price, making a profit for themselves.

 

Also Read | Unlocking the Benefits of Analytics in Wealth Management

 

Conclusion

 

In order to maintain stock prices, bring stock prices back to their true worth, improve financial ratios, or lower the cost of capital, a corporation may repurchase its shares. Stock buybacks are advantageous to investors because they frequently replace dividends. However, stock repurchases have disadvantages for business, such as potential taxes on the buybacks, a drop in credit rating, or a decline in investor confidence.