The last 20 years have seen a meteoric rise in the use of share repurchase programs as a means for corporations to raise their profits per share (EPS) outside of improving their core business operations.
But, are buy backs just a gimmick or do they genuinely benefit shareholders?
How Do Companies Buy Their Own Shares, and Why Do They Do It?
After a company has paid for its operating costs, paid the interest on its debt, invested in maintenance spending, and made any growth investments, the free cash flow that is left over can then be distributed to shareholders in the form of ordinary dividends and special dividends. This is something that we have explained in previous articles.
If a firm is unable to locate an investment that is adequate for their needs, rather than spending the money on an acquisition just for the purpose of doing so, they may sometimes use their excess cash to buy back part of their own shares.
After having them repurchased, the company has the option to either maintain them for its employee pension plan or cancel them, therefore lowering the total number of shares that are currently in circulation.
Does It Icrease Business Valuation?
The value of the individual shares that are still outstanding increases as a result of this action, despite the fact that the value of the company as a whole remains same. This is because profits per share rise as the number of shares in circulation falls.
To provide a straightforward illustration, suppose a corporation has 100 million shares of $10 apiece and a market value of $1 billion. If the company spends $100 million in cash to buy back 10% of its shares, the remaining shares are theoretically worth 11.1% more than they were, and the company's value remains the same.
The majority of the time, the announcement that a company is buying back shares will result in an increase in the price of those shares. This is partly due to the fact that the number of shares will be reduced, and partly due to the fact that the market interprets buybacks as a sign that management is optimistic about the future.
The PROS and CONS Of Buybacks
Investors do not have to pay tax on share buybacks, whereas they do have to pay tax on dividend payments; as a result, returning cash to shareholders through a buyback is more tax efficient than distributing cash in the form of dividends. This is one advantage of buying back shares as opposed to distributing cash in the form of dividends.
In a technical sense, buybacks also lower a company's cost of capital. This is because interest gained on cash is subject to taxation, but interest paid on debt may be deducted from taxable income.
As was mentioned earlier, one disadvantage is that any cash that is paid out isn't invested in expanding the business. However, if management is unable to find any opportunities that are desirable for the company, it is preferable for them to buy back their own shares rather than squander the money on a subpar investment.
Conclusion
Although the company's profits per share and return on equity will improve following a buyback because of the decreae in the number of shares (equity) in circulation, the company's true worth will not shift as a result of the transaction.
However, there is a risk that corporations, because of the pressure they are under to consistently reach short-term profitability objectives, would resort to buybacks in order to increase their earnings, rather than investing in the company with the intention of growing it over the long term.
Achille Ekeu, MBA, CVA
The Washington Valuation Group