Corporations have many pressing needs, and increasing shareholder value in the short term is one of them. What happens when revenue growth and earnings growth are not enough to achieve that objective? These corporations might resort to share buybacks. This article explains share buybacks in detail.
Share buybacks, also called stock buybacks or share repurchases, happen when companies retire some of their outstanding stock from the market. A company may choose to use the extra cash on its hands to buy back some of its shares from investors in the marketplace. The buyback exercise entails the company offering to resume ownership of some of its shares at the prevailing market price. Oftentimes, the exercise happens when management believes the market is undervaluing its stock.
How do share buybacks happen?
To grasp the concept better, consider this example. Say Company X has 1,000 outstanding shares in the marketplace, and each share is worth $20. Further, assume that Company X fails to grow its revenue for three consecutive quarters. Therefore, management decides to repurchase some of its shares to boost the company’s earnings per share (EPS).
Before the share repurchase commences, Company X has a market cap of $20,000. For the repurchase program, the company takes back 250 shares from the market at $20, leaving behind 750 shares. Before the repurchase, each share extended a 0.001% share of Company X to the stockholder. After the repurchase, each stockholder now holds 0.0013% of Company X. The result of the share buyback is that the company will have less outstanding stock in the marketplace at the same price as before the buyback.
Benefits of share buybacks
Usually, the benefits of share buybacks accrue to the company and its stockholders. One of the most apparent benefits of the exercise is increased shareholder value. The value of a company’s outstanding shares plays a major role in influencing investment decisions by investors. Once the number of outstanding shares in the marketplace falls, the share price may goes up in the short term, and the earnings per share value also goes up. As such, investors are more likely to buy the stock, because EPS is a critical indicator of a company’s value.
The second benefit of the share buyback is to reduce a company’s reliance on equity financing. Equity financing is expensive and less cost-efficient compared to debt financing. Also, share repurchases are a good way to help stockholders avoid paying taxes on their stocks. Usually, stockholders pay taxes on dividends earned from the dividend-issuing stocks they own.. A share buyback program helps those investors increase the value of their portfolio without incurring taxes. Instead, only those stockholders who sell their shares will have to pay capital gains tax.
Criticisms of share buybacks
Criticisms of share buybacks abound. For instance, share buybacks fuel income inequality within organizations. Notably, many CEOs receive their compensation in terms of stock options. Therefore, any increase in the value of the stocks implies higher compensation for the CEOs but stagnant income for employees who don’t own shares.
In addition, share buybacks take dollars away from other investment activities that could add more value to the communities that the companies serve. Moreover, share buybacks use up valuable cash that companies should be storing in case of emergency. We’ve seen a striking example of the moral hazard of share buybacks with several U.S. airlines buying back huge amounts of shares over the past few years, only to be left defenceless and cashless when the spread of the novel coronavirus jarred the airline industry.
Critics thus argue that the whole exercise is misuse of funds that should be directed to more productive things like building the company’s asset base, and that share buybacks show that companies are more interested in profits than people.