Did you know that businesses prefer to buy back their own shares paying a premium to shareholders?
Were you aware that just looking at the ratios (like EPS, P/E etc.) without questioning their sudden dip or surge can lead to serious valuation mistakes?
Do you know how business events like Stock Splits, Bonus Shares and Share Buy Backs can instantly influence the financial ratios without any change in company fundamentals?
What is Share Buyback?
Stock buybacks aka Share Buyback refers to the repurchasing of shares of stock by the company that issued them. A buyback occurs when the issuing company pays shareholders the market value (or more) per share and re-absorbs that portion of its ownership that was previously distributed among public and private investors.
From where can the buybacks happen?
The company can purchase the stock on the open market or from its shareholders directly. In recent decades, share buybacks have overtaken dividends as a preferred way to return cash to shareholders. Though smaller companies may choose to exercise buybacks, blue-chip companies are much more likely to do so because of the cost involved.
Advantages of Buybacks / Reasons for Buybacks
Since companies raise equity capital through the sale of common and preferred shares, it may seem counter-intuitive that a business might choose to give that money back. However, there are numerous reasons why it may be beneficial to a company to repurchase its shares, including ownership consolidation, undervaluation, and boosting its key financial ratios.
a) Unused Cash Is Costly
Each share of common stock represents a small stake in the ownership of the issuing company, including the right to vote on company policy and financial decisions. If a business has a managing owner and one million shareholders, it actually has 1,000,001 owners - though in different proportions. Companies issue shares to raise equity capital to fund expansion, but if there are no potential growth opportunities in sight, holding on to all that unused equity funding means sharing ownership for no good reason. So, a share buyback may also mean that a company does not really know where else to use its cash reserves more effectively.
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.
b) Reducing Cost of Equity
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. 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.
c) A good alternative to Dividends
Shareholders usually want a steady stream of increasing dividends from the company. And one of the goals of company executives is to maximize shareholder wealth. However, company executives must balance appeasing shareholders with staying nimble if the economy dips into a recession.
If the economy slows or falls into recession, the business might be forced to cut its dividend to preserve cash. The result would undoubtedly lead to a sell-off in the stock. However, if the bank decided to buy back fewer shares, achieving the same preservation of capital as a dividend cut, the stock price would likely take less of a hit. Committing to dividend payouts with steady increases will certainly drive a company's stock higher, but the dividend strategy can be a double-edged sword for a company. In the event of a recession, share buybacks can be decreased more easily than dividends, with a far less negative impact on the stock price.
d) The Stock Is Undervalued
Another major motive for businesses to do buybacks is that they genuinely feel their shares are undervalued. Undervaluation occurs for a number of reasons, often due to investors' inability to see past a business' short-term performance, sensationalist news items or a general bearish sentiment.
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 maneuver can enable businesses who still have long-term need of capital financing to increase their equity without further diluting company ownership.
But if the stock is overvalued, buybacks can be a complete waste of money.
e) It's a Quick Fix for the Financial Statement
Buying back stock can also be an easy way to make a business look more attractive to investors. By reducing the number of outstanding shares, a company's earnings per share (EPS) ratio is automatically increased – because its annual earnings are now divided by a lower number of outstanding shares. For example, a company that had earnings of Rs. 10 million in a year with 100,000 outstanding shares has an EPS of Rs.100. If it repurchases 10,000 of those shares, reducing its total outstanding shares to 90,000, its EPS increases to Rs. 111.11 without any actual increase in earnings. This may mislead some innocent investors.
f) Short Term inflation in Stock Price
Short-term investors often look to make quick money by investing in a company leading up to a scheduled buyback. The rapid influx of investors artificially inflates the stock's valuation and boosts the company's price to earnings ratio (P/E). The return on equity (ROE) ratio is another important financial metric that receives an automatic boost.
g) It is a relatively less riskier option for the management
One interpretation of a buyback is that the company is financially healthy and no longer needs excess equity funding. It can also be viewed by the market that management has enough confidence in the company to reinvest in itself. Share buybacks are generally seen as less risky than investing in research and development for a new technology or acquiring a competitor; it's a profitable action, as long as the company continues to grow. Investors typically see share buybacks as a positive sign for appreciation in the future. As a result, share buybacks can lead to a rush of investors buying the stock.
h) Defense against takeover
Buy back of shares and securities helps the promoters to formulate an effective defensive strategy against hostile takeover bids.
Downside of Buybacks
There are many drawbacks of share buybacks as well. Here are some of the important ones to be kept in mind.
a/ Lost Opportunity Cost
The biggest disadvantage of buyback is that cash used by the company to buyback the stocks has opportunity cost because that excess cash could be used by the company for variety of productive activities like starting new manufacturing plant, increasing the marketing expenditure to boost sales, recruiting new people in the company and so on which in turn can result in increase in profits of the company. Hence if the company is going for buyback it is overlooking all the other alternatives in which cash can be used - or it does not see any such opportunity at all.
b/ Promoters Den
Buyback may be used by the promoters to give a false signal about the company so as to increase the price of stocks so that promoters can sell their own stocks. Hence investors should be wary of those companies where promoter’s history is questionable because when the news of buyback comes into market domain the price of the stock rises which can be a trap for innocent investors.
c/ No long term future of the business
Many people view it as a sign that company has no profitable opportunity in the current business and that is the reason why they are using excess cash for buyback of stocks which creates negative image about the company in minds of long-term investors who are looking for capital appreciation due to growth in the company.
d/ Credit Rating Impact
A stock buyback affects a company's credit rating if it has to borrow money to repurchase the shares. Many companies to finance stock buybacks because the loan interest is tax-deductible. However, debt obligations drain cash reserves, which are frequently needed when economic winds shift against a company. For this reason, credit reporting agencies view such-financed stock buybacks in a negative light: They do not see boosting EPS or capitalizing on undervalued shares as good justification for taking on debt. A downgrade in credit rating often follows such a maneuver.
Some Recent Share Buy Back News in Media
2) Intel
3) Oil India
Summary
In general, Buybacks will increase the share price in the short term because of general euphoria and enhanced EPS and P/E ratio. But for a long term investor, the intent behind the buyback is important to understand. Be specially aware of the promoters history before taking a jump. A good blue chip may be a good bet to get into - but if you are dealing with a mid cap or a short cap stock, then please be extra careful. Even with a good blue chip, understand that the company feels that there is no better way to use the cash - and hence be vary of its long term growth prospects.
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