Buyback: What It Means and Why Companies Do It
What Is a Buyback?
A buyback, also known as a share repurchase, is when a company buys its own outstanding shares to reduce the number of shares available on the open market.
Companies buy back shares for a number of reasons, such as to increase the value of remaining shares available by reducing the supply or to prevent other shareholders from taking a controlling stake.
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How Does a "Buyback" Work?
A buyback allows companies to invest in themselves. Reducing the number of shares outstanding on the market increases the proportion of shares owned by investors.
A company may feel its shares are undervalued and do a buyback to provide investors with a return. And because the company is bullish on its current operations, a buyback also boosts the proportion of earnings that a share is allocated. This will raise the stock price if the same price-to-earnings (P/E) ratio is maintained.
The share repurchase reduces the number of existing shares, making each worth a greater percentage of the corporation. The stock’s earnings per share (EPS) thus increase while the price-to-earnings ratio (P/E) decreases or the stock price increases.
A share repurchase demonstrates to investors that the business has sufficient cash set aside for emergencies and a low probability of economic troubles. Another reason for a buyback is for compensation purposes. Companies often award their employees and management with stock rewards and stock options. To offer rewards and options, companies buy back shares and issue them to employees and management. This helps avoid the dilution of existing shareholders.
However, buybacks usage to increase executive compensation is a concern that Congress attempted to address with the Stock Buyback Reform and Worker Dividend Act of 2019 but it never made it past the Senate. Because share buybacks are carried out using a firm's retained earnings, the net economic effect to investors would be the same as if those retained earnings were paid out as shareholder dividends (tax considerations aside).
Buyback Process -
Buybacks are carried out in two ways:
A company can fund its buyback by taking on debt, with cash on hand, or with its cash flow from operations.
An expanded share buyback is an increase in a company’s existing share repurchase plan. An expanded share buyback accelerates a company’s share repurchase plan and leads to a faster contraction of its share float. The market impact of an expanded share buyback depends on its magnitude. A large, expanded buyback is likely to cause the share price to rise.
The buyback ratio considers the buyback dollars spent over the past year, divided by its market capitalization at the beginning of the buyback period. the buyback ratio enables a comparison of the potential impact of repurchases across different companies. It is also a good indicator of a company’s ability to return value to its shareholders since companies that engage in regular buybacks have historically outperformed the broad market.
Example of a Buyback
A company's stock price has underperformed its competitor's stock even though it has had a solid year financially. To reward investors and provide a return to them, the company announces a share buyback program to repurchase 10% of its outstanding shares at the current market price.
The company had $1 million in earnings and 1 million outstanding shares before the buyback, equating to earnings per share (EPS) of $1. Trading at a $20 per share stock price, its P/E ratio is 20. With all else being equal, 100,000 shares would be repurchased and the new EPS would be $1.11, or $1 million in earnings spread out over 900,000 shares. To keep the same P/E ratio of 20, shares would need to trade up 11% to $22.22.
Criticism of Buybacks
A share buyback can give investors the impression that the corporation does not have other profitable opportunities for growth, which is an issue for growth investors looking for revenue and profit increases. A corporation is not obligated to repurchase shares due to changes in the marketplace or economy.
Repurchasing shares puts a business in a precarious situation if the economy takes a downturn or the corporation faces financial issues it cannot cover. Others allege that sometimes buybacks are used to inflate share price artificially in the market, which can also lead to higher executive bonuses.
As part of the Inflation Reduction Act of 2022, certain stock buybacks for domestic public companies will incur a 1% excise tax, making them more expensive for corporations. This applies to buybacks after Dec. 31, 2022.
Why Would Companies Do Buybacks?
A buyback allows companies to invest in themselves. If a company feels that its shares are undervalued then it may do a buyback to provide investors with a return. The share repurchase reduces the number of existing shares, making each worth a greater percentage of the corporation. Another reason for a buyback is for compensation purposes. Companies often award their employees and management with stock rewards and stock options and a buyback helps avoid the dilution of existing shareholders. Finally, a buyback can be a way to prevent other shareholders from taking a controlling stake.
How Is a Buyback Done?
A company can make a tender offer, at a premium over the current market price, to shareholders where they have the option to submit all or a portion of their shares within a given time frame. Alternatively, a company may have an outlined share repurchase program that purchases shares on the open market at certain times or at regular intervals over an extended period of time. A company can fund its buyback by taking on debt, with cash on hand, or with the cash flow from operations.
What Are Criticisms of Buybacks?
Criticisms of buybacks include creating a perception that a business does not have other pathways for revenue growth. Furthermore, if a company purchases back its share and the economy takes a downturn, this would negatively impact its financial standing. Buybacks are also often criticized for artificially inflating the share price, which can be used to justify higher executive bonuses.11 Critics also argue that the 1% excise tax on buybacks will have negative consequences on the financial world.