Typically, investors calculate their return from a stock as capital appreciation plus dividend payments. For non-dividend paying companies, the growth prospects of the company decide the stock price and thereby, the return for the shareholder. However, a corporation can also provide value to a shareholder through a share buyback program. This post will look at some details of the program and how it adds value for the shareholder.
What is a Share Buyback Program?
A company with a share buyback program essentially buys its own shares from the market. This buyback reduces the number of outstanding shares and increases the value of the existing shares. The repurchased shares may be retired or kept as treasury shares.
Consider a simple example where FGH Corporation has 1,000,000 outstanding shares selling at $50 each. The company has a lot of cash on hand and decides to buyback 200,000 shares. After absorbing the 200,000 shares, the number of outstanding shares are reduced to 800,000. If the company earns a net income of $4,000,000 in the next year, then the Earnings per Share (EPS) will be $5.0 instead of the $4.0 (i.e., 4,000,000/1,000,000) it would have been without the share buyback. So, as you would realize, FGH Corporation has managed to increase shareholder value by buying its shares back.
How do Companies Buy Shares Back?
From shareholders. A company can offer to buy shares from individual shareholders by providing written notice of their interest in the number of shares, and a price range for the shares. Generally, the price offered will be higher than the market price but the offer will be set to expire after a predetermined time period.
From the market. The other option for a company is to purchase its own shares from the market just like any other investor. The company would pay the existing market price for a share, but it is likely that the price will increase once the intent to buy shares back is revealed.
Perception of the Share Buyback Program
According to company management, buying back its shares is a way to return wealth to its shareholders. Nevertheless, it can also be construed to mean that the management does not know of any better use for its cash at that point of time and hence, it deems share buyback as the best way forward. As much as a shareholder can rejoice in the increased value of their shares, it also raises the question of how the company will grow if it has exhausted its growth prospects and reached a saturation point.
A good management team will initiate a share buyback program when its stock price is cheap. This ensures that the company spends the least amount of cash possible, while accomplishing its objective to maximize shareholder value.
In addition, buying shares back when they are cheap provides the company with the opportunity to reissue them at another time without causing any dilution. Share buybacks indicate to the market that the company management considers the stock to be undervalued to such a level that it is taking advantage of the deal. They also improve the financial ratios such as Return on Assets by reducing assets (cash), lowering the P/E ratio, and increasing equity. Share buybacks are the antithesis to exercised stock options, which dilute the number of outstanding shares.
Have you held a stock that bought its shares back? Would you consider buying a stock that did not pay a dividend but has bought its shares back in the past (for the right reasons)?
About the Author: Clark works in Saskatchewan and has been working to build his (DIY) investment portfolio, structured for an early retirement. He loves reading (and using the lessons learned) about personal finance, technology and minimalism. You can read his other articles here.