You may hear news of a large firm purchasing its own shares of company stock. This is called a share buyback. While it may seem simple, it is a significant decision. Why would a firm use its own cash to purchase shares back from its investors? Because it has a strategy.
When a firm buys back shares, it decreases the number of available shares in the stock market. This then has a direct impact on the price of the shares left.
Again, it is not just about spending money. There is control, value, and growth potential involved. Investment decisions can be affected by this understanding.
In mature companies, decisions like share buybacks are often part of long-term ownership and exit planning, similar to the considerations involved when evaluating how to sell my business. This guide explains seven reasons why would a company buy back shares.
The Basics of a Share Buyback
Before we get into the details about the reasons a firm would buy its own shares, let us first define what a stock buyback is. A firm takes cash out of its own bank account and then goes to the stock market and buys its own shares like any other investor would. Then, the firm permanently removes the shares from the market, and they will no longer be available.
So, while the entire pie might get smaller, the size of the individual pieces may increase. This can be seen as self-funding. Some may question why they wouldn’t do this instead of creating more jobs or building more plants. The answer is usually more clear-cut with respect to efficiency and the value of the stock.
1. Returning Cash to Shareholders
Profitable companies can return cash to owners, who are the shareholders. A business may have excessive cash after covering operational needs. There are two primary avenues to return this cash to shareholders.
The first is via dividends, which is a direct cash payout to shareholders. The second is via share buybacks, which are potentially more tax efficient. With a dividend, the shareholder gets taxed on the dividend payout for that year.
With a buyback, the company holds a higher value for the shares that you own, and you only pay taxes once you choose to sell your stock, offering you more control over your tax obligations.
2. Boosting Financial Ratios
Wall Street admires good figures. Financial analysts scrutinize certain financial ratios to evaluate a firm’s financial performance. The most critical figure among the many is the Earnings Per Share (EPS) metric.
Let’s look at an example to illustrate this phenomenon. Say a company has a profit of 1m dollars with 1m shares. The EPS is 1. Now, the company buys back half of its shares. The company still makes 1m.
However, the profit is now divided by 500k shares. The EPS jumps to 2. The company looks more profitable even though earnings stayed the same. This can increase the stock price.
3. Why Would a Company Buy Back Shares? To Show Confidence
Leaders in a business will buy back shares if they think the stock price is too low, which would send a strong message to investors. This shows the market that they believe in the business, stating that they understand the company and its worth.
This builds trust in the market. When the leaders in a business buy back shares, investors usually take action and buy more shares. This will increase the demand for shares and help stabilize the stock price.
4. Offsetting Dilution from Employee Stock Options
Many companies in the US grant stock options to their employees, especially in the tech sector. When these employees exercise their options, the company has to issue additional shares to them. This results in an increase in total company stock.
This process is called dilution. It can be likened to adding water to soup. The more diluted it is, the less worth each share is. Companies can fix this by buying back shares. They soak up the extra shares and keep the count steady. This protects the value of the shares you own. It ensures that your piece of the pie doesn’t get smaller just because the company is paying employees.
5. Changes In The Company’s Capital Structure
Identifying the optimal capital structure of a company involves finding the right balance between debt and equity. Debt refers to loans taken by the company, while equity refers to the money shareholders invest. In some instances, a company may have excess equity and a deficiency of debt.
Equity may be more expensive than debt. In fact, a company may issue bonds to raise money, and subsequently, the company may use the money from the bonds to repurchase (buy back) company shares. This decreases the company’s equity and increases the company’s debt. While this practice may appear to be risky, it may also reduce the average cost of capital.
6. Absorption Of The Risk Of Hostile Takeovers
Once a company goes public, it opens itself to the risk of hostile takeovers, which may be a practice that a company would want to avoid. In a hostile takeover, an external investor buys shares of a company in sufficient quantity to gain control of the company.
Share buybacks can also be used to thwart hostile takeovers. By buying back shares, a company can reduce the number of shares that remain publicly available and are available for purchase by other public (and hostile) shareholders. This also protects the existing management and the vision they have for the company in the long run.
7. Scarcity of More Desirable Investment Options
This explanation is less rosy. However, it is quite real. A business needs to expand. Develop new things, or perhaps go into a different market. However, at times, a business simply runs out of big ideas.
If a mature business is unable to find a high-yielding project, it’s best not to spend. Instead, it is best to return the cash to the shareholders instead of spending it on a bad project.
A cash buyback means, “We can’t find a more promising investment right now, so putting money into our business is the most secure investment.” They show a lot of self-control. They avoid spending cash on high-risk, low-reward ventures.
Companies often compare buybacks with other investment opportunities using return-based metrics such as the Internal Rate of Return to decide where capital will generate the highest value.
Frequently Asked Questions
Q. Does a share buyback automatically increase stock prices?
Not necessarily. Although it often helps by minimizing supply, stock prices are also reliant on the company’s performance and the market. If profits fall, stock prices may also fall despite a share buyback.
Q. Is a dividend more favorable than a share buyback?
That’s subjective and primarily dependent on what the person seeks to achieve. A dividend pays out regular cash and provides a source of income; however, a tax is levied immediately. On the other hand, share buybacks increase the stock value over time, and the tax is deferred until the stock is sold.
Q. Can a company buy back too much stock?
Yes. If a company uses most of its cash on buybacks, it may lose opportunities to invest in new products or growth. It also leaves them with less cash for emergencies.
