Share Buy Backs
Uploaded by barkhaamonkar on Sep 20, 2005
Definition: The purchase by a listed company of its own shares either in the open market or by tender offers. Sometimes a company has surplus funds that it does not need for its operations. It can use those funds to expand its operations (e.g. buy new businesses) or it can distribute them to stockholders. One-way of distributing funds to shareholders is to have a share buy back, wherein the company buys back some of its shares from existing stockholders.
COMPANIES DO IT FOR FIVE REASONS:
• To increase the share price
• To rationalise the capital structure - the company believes it can sustain a higher debt-equity ratio
• To substitute the dividend payouts with share repurchases (because capital gains may be taxed at lower rate than dividend income)
• To prevent the dilution of earnings caused, for example, by the issue of new shares to meet the exercise of stock option grants
• To deploy excess cash flow and return it to shareholders
• A company normally buys back shares when it feels the stock is undervalued, or when it has enough cash to reward investors by purchasing the shares at a price higher than the market value.
EXAMPLE OF A SHARE BUY-BACK
Company A has 100 shares issued and makes a profit of $50. This means a shareholder is getting a return of 50 cents a share ($50/100). This is the Earnings per Share or EPS. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $7.50. Suppose that the company buy back 25 shares. A shareholder who retains their shares now earns 67 cents ($50/75) on each share held. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $10.
WHEN A COMPANY SHOULD BUY BACK SHARES
So a company can add value to its shares by buying some of them back:
a. Where it has surplus funds;
b. Where it can buy them back at a price below intrinsic value.
DON'T BUY BUYBACKS BLINDLY: FOR INVESTORS
• Often there is at least a short-term up tick in the stock price after a buyback announcement, and certainly there is often a bounce up after the buyback itself is actually accomplished. So, some companies might like to divert attention away from a revenue problem by being able to show an increase in the stock price. Why would there be such an increase? Because a company usually...