You may have heard about stock buy backs in the news as they are relatively common for publicly traded companies. But what are they and why are they done? This article answers the question of what are stock buybacks?
To start, a stock buyback simply occurs when a corporation purchases back its stock from those who are holding it with cash that it has on hand. There are several different ways that buybacks can be transacted.
How does a company conduct a stock buyback?
In order to answer the question of what are stock buybacks, you should understand how a company conducts one.
The first way that a company could buy back its stock, and also probably the easiest way, is by just purchasing them in the open market like anyone else would.
Instead of directly purchasing the shares from the market, the company could make a fixed price tender offer to repurchase a specific number of shares at a fixed price. This fixed price is is usually at a premium to the current market price of the shares. For example, if a share is currently trading at $12, the company may make a fixed price tender offer to buy back 1,000,000 shares at $13.
Another buy back method is by negotiating directly with a large shareholder. The reason the company would do this is to keep a large block of trades from entering the market. This could negatively affect the price of the stock.
Shares that are repurchased by direct negotiation could either be bought at a premium or at a discount. If a large holder is threatening to get access to the company’s board of directors through a hostile takeover, the company may make that holder an offer at a premium which would be profitable that shareholder. This is a practice known as greenmail. Before you decide to do this, the IRS introduced an excise tax of 50% on any greenmail profits.
If there is an institutional investor who holds a large amount of shares, they may negotiate with the company to buy back the shares at a discount because of a large liquidity need.
Why does a company buy back stock?
Now that you know how a company would execute a share buyback, a crucial factor in answering the question of what are stock buybacks, let’s focus on why a company might do this.
One reason a company may buy back its shares is to give a cash distribution to its shareholders. Traditionally a company would pay a per share dividend to its shareholders to return capital, however dividends are usually taxed at regular income tax rates.
If the company bought back shares to return wealth to the shareholders, the amount returned would be taxed at the lower capital gain tax rate, ultimately giving the investor more cash.
As mentioned in this article, the price of a company’s stock is determined in the secondary market by the relationship between the supply and demand of shares. If the price of the underlying stock is decreasing (which can be attributed to weakening demand for the asset) the company could buy back some of their shares on the market. Doing this would increase demand and in return either increase the stock price or at least stop the price from declining more.
When a company decides to acquire another company they can either purchase the company with cash, offer their shares to purchase the company, or a combination of the two. A company announcing that they are going to be buying back a large amount of their shares might signal that they have a future acquisition in mind.
EPS, or Earnings Per Share, is a measurement of how much net income is allocated to each outstanding share, or in other terms, the per share profitability of the company.
EPS is calculated by dividing the firm’s net income, less preferred dividends, by the weighted average number of shares outstanding. A company could easily make this measurement higher, and in return make the company look more profitable, by decreasing the number of shares outstanding. To do this, the company could just buy back some of its shares.
However, companies who are spending their cash on buying back shares could just use this cash for capital expenditures. Any capital expenditures should ultimately increase the company’s net income.
Instead of decreasing the denominator of the EPS formula by repurchasing shares, the company could just increase the numerator to increase EPS.
Another reason that the company would repurchase some of their stock is because they think that the shares are undervalued (the fundamental or intrinsic value of the stock is greater than its market price).
Essentially, they would be buying the stock at a discount. Any investor can try to determine what they think the intrinsic value of a company’s stock can be however there are many calculations that go into finding this number.
No other investor’s fundamental value calculations would be as accurate as the company’s itself because they know everything that is going on within the company such as new projects that they are taking on, future earnings reports, and how their sales pipeline looks.
Summary – What are stock buybacks?
When you see a company issue a share buyback it should really make you think why. There are several different reasons as to why they would do this, and it is up to the individual investor to decipher it.
The company could repurchase its shares for any of the previously mentioned reasons, or for a combination of them.