Understanding Why a Company may Decide to Complete a Share Buyback

Companies will often take part in a share repurchase program. However, the reasons for the share buyback are often unknown and can lead to different outcomes.

Have you read a company’s quarterly update or listened to their earnings call and heard of a plan for stock buyback or a stock repurchase? When you take a quick glance from the outside, it doesn’t necessarily make sense for a company to want to buy back shares that they could be selling to outside investors and make money.

However, by the end of this, you will understand the reasons for a share buyback, and some of the advantages that it can provide to a company. Some reasons are for good, some are to try and throw a Hail Mary to save a business.

What is a Share Buyback?

A share buyback is exactly what it sounds like. This is when a company or corporation purchases a large amount of its own stock. They can accomplish this by purchasing on the open market, or they can go directly to their investors and purchase their shares back.

Usually, during a share buyback, the company will retire the stock and make them no longer available for purchase. One of the big reasons for a share buyback from a company is to attempt to enhance the shareholder value.

A share buyback is typically a sign of a business that is willing to reinvest or lower its cash flow (which is usually a good thing). One of the biggest reasons for a share buyback is the market pop it typically will provide.

This strategy is typically a good thing for an investor, but you must be careful to make sure the repurchase is for the right reasons and not misleading.

In the right scenario, this is a prime example of supply and demand. If a company has a share buyback, that puts fewer shares in the market, and creates a higher demand for what is left. Additionally, there will be fewer shares with claims to the company’s earnings which should increase the price.

There are six big reasons for a share buyback, below is an explanation of each and how they can help to increase a company’s stock price which is always the goal.

Boost Undervalues Shares:

When a company believes that its shares are undervalued, it will often execute a share buyback to try and give the stock a bump in price.

In this scenario, a company is showing you that they believe in themselves for the long run and they want the market to know. They are willing to use their own cash as collateral to prove their belief and get the market back on their side.

A prime example of a company getting undervalued is when the market doesn’t understand its full business. Yes, every business is creating a good and selling it to consumers. But oftentimes there are advantages that the market may not know about or give them credit for when evaluating their stock.

A real-life example may be a distribution company named 123 that delivers all products to outlet store ABC. Distribution company 123 has continued to report high earnings and a good balance sheet, but the stock price isn’t reflecting the profit and loss statement. What the market doesn’t know is company 123 has the patent for 40% of the products produced that go to ABC’s stores.

Company 123 can buy back a piece of their shares to pop the stock, get investors’ attention, and bring to light the reasons why they see their company as undervalued. Typically, the biggest reason for a share buyback is for a company to show they are undervalued.

Increase Earnings Per Share (EPS):

Another reason for a share buyback is to increase the earnings per share (EPS) of the specific stock. This is what I referenced above about supply and demand.

This is fairly simple arithmetic, if you remove outstanding shares with a stock repurchase, the fewer number of shares that the company’s earnings or profits will be distributed to.

An increase in the stock’s EPS often leads to an increase in the stock price, which adds value to the investor. It typically creates a higher demand for the shares as well, which is another benefit if you already own the stock.

A real-life example would be a company that has profit-sharing with five employees currently. In January let’s say they had profits of $1,000 to split between the five company employees, or $200 each. The company realized that one of the employees really wasn’t working and they let that person go. In February the company has profits of $900 (less than Jan), but distributions are only to four people, so they still receive $225, a raise from the previous money.

Manage Number of Shares Outstanding:

Another one of the reasons for a share buyback is for the company to be able to manage the number of shares outstanding. This is somewhat like the reasoning above about increased EPS, but slightly different at the same time.

Remember, a lot of companies give out stock options at bonus time and/or as compensation to high-up executives. And while they see the value in them, they have nothing at stake to claim the funds.

A typical investor like me and you invest our money for the long run (typically). We find a company that we want to invest in, buy the stock, and let it ride until retirement.

These executives who receive large chunks of stock options typically don’t have any reason to hold their positions. Especially if they see the stock price remaining flat in the short-term.

The bottom line, large chunks of the stock options can be cashed out making the number of outstanding shares in the market much greater. In order to maintain optimal levels of outstanding shares, companies will often participate in a share buyback, anticipating the large selloff.

While a share buyback can pop the stock, a large sell can also deflate it. For this reason of a share buyback, the company is playing defense more than offense.

Reduce Cash Outflow/Tax Advantages:

When looking at reasons for a share buyback, one of the most overlooked ones can be for a company to reduce cash outflow. Often by a company buying back shares, they can reduce their spending without increasing their dividend.

Now, losing out on an increased dividend can initially sound like a bad thing for an investor as they are missing out on that quarterly payment, but that’s not the entire story of this strategy.

Yes, the company is saving their money by not paying a dividend, but they are still investing cash to buy back the stock. The company is saving value by retaining something (the share) that has value, and the investor gets a benefit as well.

The investor will get the pop from the stock increase, and not have increased income from an increase in the dividend payment which can save them in taxes. The money received from a stock buyback is treated as a capital gain which has a lower tax rate than what is charged for dividends.

Don’t get me wrong, a guy that has a couple of hundred shares may not see a huge value in this, but an executive or wealthy trader who could have hundreds of thousands of shares could see a huge benefit from such a move.

Reinvest in the Company:

If you have read anything else that I have ever posted, you’ll know that I see cash as the least valuable asset right now, especially with inflation going through the roof. You certainly need to make sure you have enough liquid cash to take care of any type of emergency that may pop up, but having a ton of cash in your savings earning less than half a percent on interest is not a great strategy.

The same thing is true for a major corporation. If they are sitting on a ton of cash, they are wasting opportunities. Another reason for a share buyback can be an investment.

The company may not have any great opportunities to purchase assets to expand their business, so they invest cash in themselves by a share buyback to get rid of some of that cash.

Typically, these share buybacks happen in the range of hundreds of millions of dollars. So, even if a major corporation can earn one percent on their money in savings, a stock pop of even five percent can pay an additional four percent on their money. Using $100 million as the example amount of a buyback, that creates an additional $4 million for the company in additional profits.

This is obviously a much larger scale than your personal account, but reinvesting company cash to generate higher returns is another fantastic reason for a share buyback.

Defend Hostile Takeover:

As you’ve read above, there are many reasons for a share buyback from a company, but there is one more I would like to cover today. That reason is to prevent a share purchase takeover.

What exactly does that mean? If there are enough outstanding shares and current shareholders willing to sell, another person or company can purchase majority power. Someone or something needs to own over 50 percent of the shares to have majority ownership.

By doing a stock buyback, a company can protect itself by limiting the number of outstanding shares. Where there is a will, there is a way to find the shares, but this defense mechanism can be useful.

I work for a company in which this happened just last year. I wouldn’t call it hostile, but another company started buying our shares quickly. Within two weeks they owned a majority and took over our company. Truthfully, this was for the best in my scenario, but that is not always the case.

How a Share Buyback can Negatively Affect Investors:

The reasons for a share buyback often tend to favor the company and investor. However, there are a few scenarios that you should be aware of that can make things not go your way, specifically as a stock owner.

While most companies complete a stock repurchase to boost an undervalued stock, other times companies can do this to inflate the price to attract investors.

If you already own the stock you shouldn’t have a huge effect as it will likely blip up, and then come back down. There is a chance it could dip even lower from the miss-timed strategy, but if you buy in when you see the increase, you could be in for a good-sized loss.

A company can also just be delaying disaster with a share buyback. This can sometimes be the Hail Mary attempt to offset a poor quarter or a struggling economy. A share buyback can raise the EPS temporarily and give a slight bump in stock price to keep a company going for a few more months.

And last but not least, another reason for a share buyback is for a company to be cheap. I mentioned above that a positive can be an increase in EPS, but that also means no increase in the dividend for the investor.

While no increased dividend can be a positive for major shareholders, for average joes like me and you, it really doesn’t have a huge effect. Sometimes companies can buy back shares to increase the value of the company through a share price and escape a decrease in a dividend which is money that goes directly to investors’ pockets.

As you can see, at the end of the day, the reasons for a share buyback are long. And if the intentions are correct, it can typically end up being a positive for you as an investor.

However, if a company is trying to salvage their company for a few more months, it can make for some painful times in your investment portfolio. Much of this depends on proper timing. Even if a company has good intentions, it can still go sideways if executed at the wrong time.

As a shareholder in any company, I would challenge you to review any documents you can get your hands on when a company announces a share buyback. Doing your homework is always the safest bet.

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