Why do Companies buyback their shares?
Team Veye | 11-Mar-2019
A Stock or Share Buyback can be defined as repurchasing of shares of stock by the issuing company. Such re-purchasing occurs when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously distributed among public and private investors. Such share buyback announcements tend to excite the investors as the buyback price is usually at a premium compared with the prevailing market price at that point.
But is it is worth exploring as an option? Well, that needs to be checked before you take the plunge as this may only turn out to be a short term gain. That depends from company to company and under what circumstances a particular company has announced share buyback. One should study and analyse the offer before tendering shares.
Why do Companies go for a share buyback?
Attempt to boost earnings per share (EPS): One of the most common reasons, because share buyback reduces outstanding shares in the market and acts as a quick fix for the Company’s Financial Statement.
Let’s take a look at the following example to attain more clarity:
Company ABC announces a share buyback program to repurchase, let’s say, 10% of the outstanding shares at current market price.
The company had $1,000,000 in earnings spread out over 1 million shares, or 1,000,000 shares, equating to EPS of $1.
EPS = Total Earnings/Total number of shares.
Let’s say with a PE of 30, the shares traded at $30.
Market price = P/E X EPS.
Now, all else being equal, if 100,000 shares are repurchased, the new EPS would be Total Earnings/Number of shares, which in this case would become 1,000,000/900,000= $1.11. Now, at a PE of 30, the shares would trade up by (1.11 x 30) = $33.30
Undervalued shares: At times when the company feels the shares are undervalued, a share buyback is used to pump up the stock price, which acts like a support or new base for the stock. A buyback reassures investors that the company has confidence in itself and is determined to work towards creating value for shareholders.
If a stock is dramatically undervalued, the issuing company can repurchase some of its shares at this reduced price and then re-issue them once the market has corrected, thereby increasing its equity capital without issuing any additional shares. Though it can be a risky move in the event that prices stay low, this manoeuvre can enable businesses who still have long-term need of capital financing to increase their equity without further diluting company ownership.
Lack of growth opportunities: This is a controversial point, but quite relevant, especially in the case of a specific industry. For eg - IT industry which may have quite a lot of cash on the books but has fewer growth opportunities. Businesses that have expanded to dominate their industries, for example, may find that there is little more growth to be had. With so little headroom left to grow into, carrying large amounts of equity capital on the balance sheet becomes more of a burden than a blessing. Shareholders demand returns on their investments in the form of dividends which is a cost of equity – so the business is essentially paying for the privilege of accessing funds it isn't using. And, buying back some or all of the outstanding shares can be a simple way to pay off investors and reduce the overall cost of capital.
Our analysts reckon that this buy back strategy is not suitable for investors with Long term investment appetite, as the gains are only short term and the stock price growth over longer term may easily surpass any such gains.
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