Investing Basics: Share buybacks, are they good or bad for investors?

Ever peeked into a company’s financial report and stumbled upon the enigmatic term “share buyback”? A share buyback is a company’s way of “flexing” its financial capacity. But what does it really signify? Read more to understand how a company’s share buyback will impact you as a current shareholder or pique your interest as a prospective one.

What is a share buyback?

A share buyback is when a company repurchases its own shares from shareholders. This reduces the total number of shares available. The goal is to increase shareholder returns by spreading profits over fewer shares. Consequently, when a company buys back its shares, it can lead to higher share prices.

What are the different types of buybacks?

On-market buybacks happen on exchanges during regular trading. The buyback price will just be the market price if it is an on-market buyback.

Off-market buybacks occur off the exchange, when companies present a direct offer to shareholders. There will be a designated buyback price set by the company, usually a price at which the company is willing to repurchase its shares from shareholders.

Off-market buybacks can be “equal access”, meaning it involves all shareholders, or “selective”, which is when the company offers to buy back shares from a particular group of shareholders. This latter option requires a shareholder vote, with those who are part of the selling group excluded from voting.

How share buyback work

A share buyback lowers the total number of shares available, leading to higher earnings per share (EPS). This boosts the value of the remaining shares. Repurchased shares are either cancelled or held as treasury shares, no longer publicly held. Financially, a share buyback impacts the company’s financial statements. It reduces available cash on the balance sheet by the buyback amount, and also decreases shareholders’ equity by the same sum on the liabilities side. 

Here’s a breakdown of how share buybacks work:

Legal requirements: Companies planning to conduct a share buyback are required to disclose their intentions and details to the Australian Securities and Investments Commission (ASIC). 

They must also inform the market through a formal announcement, outlining the reasons for the buyback, the maximum number of shares to be repurchased, and the period during which the buyback will take place.

Frequency: There is no set frequency for conducting share buybacks in Australia. Some companies might engage in occasional buybacks, while others might incorporate them as a regular part of their capital management strategy due to the company’s financial position, cash reserves, and strategic goals.

Limitations: The Corporations Act 2001 sets certain limitations on share buybacks in Australia to protect the interests of shareholders and maintain market integrity. 

It cannot use more than 10% of its issued capital in any 12-month period for on-market buybacks. Additionally, companies are prohibited from buying back shares at a price that exceeds the higher of the market price and the last independent sale price over the preceding 15 days.

Fair pricing: The buyback price must be determined fairly and equitably. Companies need to ensure that the buyback price is not influenced by insider information or any form of market manipulation.

Reporting: After the buyback is completed, companies are required to provide information on the results of the buyback to ASIC and the public on a daily basis while the buyback is open and the Company is purchasing shares. This includes details on the number of shares repurchased, the price paid, and any changes to the capital structure.

Why do companies buy back their own shares?

Undervaluation: Companies may believe their stock is undervalued in the market and repurchasing shares can be a way to invest in their own stock at a perceived discount.

Financial ratios: Fewer shares mean faster earnings per share (EPS) growth as revenue and cash flow rise. Share buybacks also reduce total assets, impacting metrics like return on assets and equity or ratio of debt to equity.

Capital management: Companies with excess cash may choose buybacks as a way to efficiently use surplus cash they don’t plan to use for acquisitions, especially when growth opportunities are limited.

What’s the difference between a dividend and a share buyback?

Companies use dividends and share buybacks to give cash to shareholders. Dividends benefit everyone, while buybacks only help those who join in. Both can raise returns, but vary in terms of when those returns are received.

Dividends are immediate profits paid to shareholders, bringing instant returns (and taxes). Buybacks lower available shares, likely lifting share prices in the long run.

However, profit is only gained when selling shares. This means tax on increased value is delayed until the shares are sold.

What happens if shareholders choose to join or abstain from share buybacks?

Participating shareholders are offered a chance to liquidate their shares and potentially earn profits if the selling price surpasses their initial investment, serving as an alternative to receiving dividends. 

If a company buys back a significant number of shares, the total shares outstanding in the market decrease. Shareholders who choose not to participate in a buyback generally retain their ownership in the company, and there’s a chance that their percentage ownership will slightly increase.

If the buyback represents a small portion of the total shares outstanding, the overall impact on non-participating shareholders is relatively minor.

How buybacks impact company’s cash position

A successful buyback can provide better returns for shareholders than keeping extra cash reserves, and it also increases their ownership value.

However it also comes with opportunity cost and reduced flexibility. The cash used for a buyback could have been used for other investments, acquisitions, research and development, or expansion projects that could generate future growth and revenue. Reducing the company’s cash reserves through a buyback might limit its ability to weather economic downturns or unforeseen challenges.

Moreover, if the company executes the buyback when its shares are overvalued, it could lead to a poor allocation of resources and result in negative long-term consequences.

From the shareholder perspective, those who prefer receiving regular dividends might be disappointed if the company uses its extra cash for a buyback instead of distributing dividends.

Benefit of share buybacks for shareholders:

Enhanced Ownership Stake: With fewer outstanding shares, each shareholder’s ownership stake increases, potentially leading to a larger portion of profits and assets.

Earnings Per Share (EPS) Growth: Reduced shares can lead to higher EPS since earnings are distributed among fewer shares, therefore attracting potential investors.

Dividend Increase: As earnings are divided among fewer shares, companies may increase dividends per share, resulting in higher dividend payments to individual shareholders.

Improved Market Value: A lower supply of shares can drive up demand, leading to increased stock prices and improved market value.

Return on Investment: Shareholders’ return on investment can improve due to higher EPS and potential capital appreciation.

Signal of Confidence: A buyback can signal management’s confidence in the company’s future, encouraging investor trust.

Reduced Dilution: Buybacks counteract dilution from stock options and convertible securities, helping maintain shareholder ownership.

Potential Upside: If shares are undervalued, buybacks can offer shareholders an opportunity to benefit when stock prices rise.

Downsides of buybacks for shareholders

Uncertain Returns: Buybacks don’t guarantee immediate share price increases, and shareholders may not see anticipated gains.

Market Timing Risks: Shareholders hope for two main benefits during a buyback program; a notable increase in their ownership stake and improved returns on their investment. This optimism stems from the assumption that the company will use its resources wisely and buy back shares at opportune times, enhancing the value of shareholders’ holdings.

However, if the buyback takes place when the stock prices are high and the company ends up paying a premium, the outcomes may not meet expectations. The company just spends more money but only gets a smaller number of shares in return. 

Consequently, the increase in ownership stake might be smaller than shareholders hoped for. Moreover, the anticipated improvement in returns might not materialise as expected, since the stock prices were already high when the buyback was executed.

Consistent high-priced buybacks can strain finances, affecting growth and essential activities. To counter these risks, companies must be cautious not to overpay for their own shares, and shareholders should assess the company’s strategy to ensure buybacks benefit them.

Reduced Dividends: Money spent on buybacks might reduce funds available for dividends, affecting income for income-seeking investors.

Debt Impact: If companies use debt for buybacks, increased debt levels might affect financial stability and risk. Debt can strain cash if situations worsen, potentially causing credit downgrades after debt-backed buybacks. 

Stock Price Manipulation: Excessive buybacks might artificially inflate stock prices without fundamental improvements.

Should I participate in a share buyback?

There is no universal answer as the decision is personal to each shareholder. Some shareholders might prefer to hold onto their shares for potential long-term growth, while others might choose to sell their shares back to the company for immediate liquidity or profit-taking.

However, here are some key points to consider:

Company’s Financial Health: Before participating in a share buyback, it’s important to assess the company’s financial stability and overall health. A buyback can be a positive sign if the company has excess cash and believes its shares are undervalued. 

However, if the company is struggling financially, a buyback might be seen as a way to artificially boost the stock price without addressing underlying issues.

Investment Goals: Consider your investment goals and time horizon. Are you looking for short-term gains or long-term growth? A buyback could potentially lead to short-term price appreciation if it increases demand for the stock, but the long-term benefits depend on the company’s ability to maintain sustainable growth.

Valuation: Evaluate the current valuation of the company’s shares. If the company is repurchasing shares at a price significantly lower than its intrinsic value, it could be a good opportunity to participate. However, if the shares are already overvalued, the buyback might not provide as much benefit.

Diversification: Consider how participating in a share buyback affects your overall portfolio diversification. Overconcentration in a single stock can increase your risk exposure.

Future Growth Plans: Assess the company’s plans for growth and expansion. Ensure that the company has a clear strategy to use the repurchased shares effectively and generate higher returns in the future.