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Share buyback: What’s the meaning?
The practice of share buybacks has grown dramatically in recent years, but what are they? - and more importantly - are these share repurchases good for your investments?
You might have seen a headline like ‘Stock X rises 5% as investors cheer £500 million new buyback program’. This guide explains this sentence and more, so you’ll know how to factor in share buybacks into your investment approach.
You might have seen a headline like ‘Stock X rises 5% as investors cheer £500 million new buyback program’. This guide explains this sentence and more, so you’ll know how to factor in share buybacks into your investment approach.
QUOTE
"The best use of cash, if there is not another good use for it in business, if the stock is underpriced, is a repurchase."
Big ideas
- Stock buybacks can have a direct effect on shareholder wealth because the reduced number of shares boosts earnings per share, something that investors usually see as a positive for the share price.
- Analysing the effects of stock buybacks on fundamental metrics like earnings per share and market position makes it possible to understand how they shape its market pricing.
- Looking for smart buybacks involves putting the decision to repurchase shares in the context of the company’s financial strength.
What is a stock buyback?
DEFINITION
A situation where a firm decides to repurchase its own shares from existing shareholders is referred to as a stock buyback.
This reduces the number of shares available in the open market, thus enabling the firm to concentrate ownership and, in most cases, add shareholder value.
This reduces the number of shares available in the open market, thus enabling the firm to concentrate ownership and, in most cases, add shareholder value.
What does a stock buyback do?
There are several impacts of stock buyback. First, it may serve as a signal of confidence in terms of its financial health by indicating that its management believes that the shares are undervalued.
Similarly, this action can also enhance financial ratios like earnings per share (EPS) as fewer shares are used to distribute the same amount of earnings.
Additionally, buybacks can be utilised as efficient tools for managing excess cash reserves in place of holding cash or making less profitable investments.
In many cases, a repurchasing process incurs an immediate rise in the share price for various reasons. Firstly, according to the supply and demand rule, if you lessen the number of outstanding shares, then all remaining ones will rise in value. On top of that, just doing a repurchase act itself is seen positively in the market, as it might draw the attention of more investors.
The long-term impact of share buybacks is highly debated and depends on the subset of stocks analysed as well as the time period considered. For instance, in the years leading up to the 2020 pandemic, companies in the S&P 500 repurchased stock did better than those that didn’t.
The long-term impact of share buybacks is highly debated and depends on the subset of stocks analysed as well as the time period considered. For instance, in the years leading up to the 2020 pandemic, companies in the S&P 500 repurchased stock did better than those that didn’t.
If you choose not to sell your shares during a stock buyback of a company you're invested in through your Trading 212 account, your shares will remain as they are in your account.
The buyback might lead to an increase in the share price due to the reduced supply of shares in the market, which could potentially increase the value of your holdings. However, your actual share count will not change as you have not participated in the buyback process.
How does a buyback work?
A buyback works through a company allocating a portion of its financial resources to purchase its own shares. There are different ways a company can go about this (discussed below).
Buyback yield is a measure that tells us what percentage of its own value a company is putting into buying back its own stock.
Buyback yield is a measure that tells us what percentage of its own value a company is putting into buying back its own stock.
FORMULA
Buyback yield = Total amount spent on buybacks / Market capitalisation
Types of stock buybacks
Different kinds of stock buybacks have different implications for the business and have various characteristics. Understanding them can enable investors to figure out what the organisation wishes to achieve and how it may affect shareholder value.:
Open Market Buybacks
Open Market Buybacks are when companies buy shares directly from the market over time. This is the most common way as it allows flexibility since the company can decide when and how many shares to purchase based on market conditions and the availability of cash to purchase them.
Fixed-price tender offers
They involve a set number of shares being put up for sale at an agreed-upon price, which usually has some premium added on top of the prevailing market price. Shareholders would then be compelled to offer some of their shares for sale within a prescribed period.
Dutch Auction Tender Offers
This type of buyback is characterised by shareholders indicating, within a specified range set by the company, the number and price of shares they are ready to sell. The lowest cost at which the desired number of shares can be bought by the business determines which shares are bought and sold.
Direct negotiations
Direct negotiations are if there is a single major shareholder or group of shareholders that can be employed by companies in share repurchase decisions, typically for bigger transactions.
Who benefits from a stock buyback?
Share buybacks increase remaining share value by reducing supply and potentially raising earnings per share (EPS), which may benefit shareholders. Besides, tender offers allow individuals owning such stocks to dispose of them at premium prices imposed by those firms.
From a corporate perspective, repurchasing its own stock is one way through which cash flows can be returned to shareholders, financial ratios can be improved, and confidence about the future business performance is made known. Additionally, it gives the firm more control over its ownership structure.
Also, sometimes management may benefit as their compensation is linked to metrics like EPS or the share price, which might be enhanced by buybacks.
From a corporate perspective, repurchasing its own stock is one way through which cash flows can be returned to shareholders, financial ratios can be improved, and confidence about the future business performance is made known. Additionally, it gives the firm more control over its ownership structure.
Also, sometimes management may benefit as their compensation is linked to metrics like EPS or the share price, which might be enhanced by buybacks.
Pros and cons of stock buybacks
Pros of stock buybacks | Cons of stock buybacks |
The result is a higher earnings per share (EPS) and likely a stock price increase that benefits shareholders. | These funds could have been used for such things as research and development, acquisitions or debt reduction, which would add more value over time. |
A company is only able to buy back shares when it has excess cash and believes that its stock price is undervalued, making it a very efficient use of capital. | One risk associated with buybacks is the short-term orientation on stock performance, whereby long-term company growth and investments can suffer. |
They might mean that the management thinks that the company’s share price is too low, thus increasing investor confidence as well as attracting new investors. | Buybacks just manipulate EPS artificially to increase the share price, which is arguably misleading to investors. |
Capital gains taxes are usually lower than those on dividends in many countries, implying that buybacks are generally more tax-efficient than dividend payments. | Sometimes, money spent in buying back shares could have been better used elsewhere, such as financing sudden unexpected opportunities or ensuring liquidity during downturns, for example. |
Might prevent takeovers by increasing the percentage of ownership for the loyal shareholders that remain, including insiders. | When share prices go up due to buybacks, the most important beneficiaries are large stockholders and management, possibly at the expense of average investors and workers. |
Recap
Stock buybacks, when a company repurchases some of its outstanding shares, generally lead to higher earnings per share and boost the share price over the short term, though longer-term benefits are more disputed.
They take multiple forms. These forms include Dutch auction tender offers, fixed price offers, open market purchases etc. The strategic advantages of buybacks must be weighed against these risks and broader financial implications.
They take multiple forms. These forms include Dutch auction tender offers, fixed price offers, open market purchases etc. The strategic advantages of buybacks must be weighed against these risks and broader financial implications.
FAQ
Q: Why do companies buy back shares?
Companies buy back shares to improve financial ratios like EPS, return excess cash to shareholders, control ownership structure, and signal confidence about the company’s perceived undervaluation.
Q: Are share buybacks better than dividends?
Share buybacks can be better than dividends in terms of tax efficiency and flexibility, but the choice depends on shareholder preferences, company strategy, and financial circumstances.
Q: What happens to the share price after a buyback?
The share price could go up due to lower supply and higher earnings per share, but it cannot be assumed without considering the general perception among market players and other factors that affect corporate financial health.
Q: Is a share buyback a good thing?
Share repurchases can be good when they indicate good things about the health of the company. Still, they may also show that there are no better opportunities for investment and can give false impressions about real financial performance.
Q: How do you carry out stock buybacks?
An individual would never do a buyback, it is only In the case where a firm buys its shares in the market, reducing the amount of shares outstanding.
Q: Is it mandatory to sell your shares on a buyback?
Selling back one’s shares during this period is not mandatory, and shareholders have an option of whether to do so or not.
Q: Who profits from stock buybacks?
The main beneficiaries of stock buybacks tend to be shareholders whose stocks have the potential to appreciate in value and improved financial ratios; additionally, the corporation may gain control over its capital structure.
Q: What are some problems with buying back stock?
This move might divert funds towards non-essential activities, while it also subjects an organisation at risk of overpricing, after which it may experience cash scarcity on future contingencies. It may also show management prioritising short-term stock prices ahead of long-run growth.
Q: Do stocks go up after buybacks?
Shares often rise following such exercises due to reduced supply as well as greater liquidity measures although this trend depends on factors like general market conditions together with corporate performance.
Q: Why would you pay dividends instead of doing a share repurchase?
Income-focused investors who put heavy weight on things like dividends per share and dividend yield would potentially be more attracted to a company that pays more dividends at the expense of doing fewer buybacks.
Q: Do you need to pay tax on the buyback of shares?
Taxes have to be paid when one disposes of shares in a buyback, but not if you hold onto them.
Tax treatments depend on the individual circumstances of each person and might be subject to change in the future.
Tax treatments depend on the individual circumstances of each person and might be subject to change in the future.
Q: Are stock buybacks a waste of money?
These transactions may be considered wasteful if they do not align with the company’s overall strategic objectives or if executed at inflated prices.
Q: Why do shares fall after buyback?
If share repurchase programs are perceived as a detrimental sign for future growth rates or potential insolvency, such measures can lead to lower market valuations.
