Whenever you go to the gym you will see a variety of characters who are all using different methods of working out to try and better themselves. Some of the exercises they choose can be something they have seen off of a Youtube video or from a friend who is extremely fit. While everyone is trying to get into better shape, I think we can all agree that there are some methods to working out that can be more harmful than good. When it comes to working out there are certain ways for a person to better themselves depending on their body and their level of fitness. The same can be thought of when we consider a company performing a share buyback (aka share repurchase program). In today’s article, I’m going to be discussing when a share buyback plan is beneficial to a company and also when it is more harmful than good.
A company performs a share buyback when they repurchase some of their outstanding shares in the marketplace. In most cases, the company believes that the shares are undervalued. The company buys shares directly from the market or offers its shareholders the option of tendering their shares directly to the company at a fixed price.
The biggest benefit of performing a share repurchase is that it increases shareholder’s earnings per share. Earnings per share is calculated by dividing a company’s net income by its number of outstanding shares. Let’s say Disney has total net income of 3 billion dollars and it has 2 million shares outstanding.
3 billion/2 billion= EPS of $1.50
If Disney performed a share buyback and repurchase 1 billion shares (dramatic example) the new EPS would be:
3 billion/1billion= EPS of $3
The share repurchase immediately elevates market value and we can expect a rise in share price as a result. That is also why the opposite is true when a company issues more outstanding shares as we will see the stock price drop. More outstanding shares dilutes earnings per share.
Reasons for Share Repurchase
- Increase EPS
As stated above, one of the main reasons for a share buyback is to increase earnings per share for investors. The company using excess cash reserves to buy back shares shows that they believe those shares are undervalued. The buyback will also improve other financial ratios of the company such as reducing the price to earnings ratio (P/E ratio) which is one of the top ratios value investors look at.
- Compensate Executives
When the company buys back outstanding shares it is now known as Treasury Stock. Treasury stock can be used to compensate company executives in the form of stock options. This is a get way to incentivize them as employees of the company and reward them for their hard work.
- Use for Mergers/Acquisitions
The company can also use the Treasury stock as financing for future mergers and acquisitions. If they want to buy out another company, they can use the Treasury stock to fund the deal rather than taking out debt financing.
As I mentioned in the beginning of this article, sometimes share buybacks can be done for the wrong reasons and can hurt the company in the long run. Let’s take a look at some drawbacks to a repurchase.
- No Growth Plans
Sometimes a repurchase can be viewed negatively if investors believe the company does not know what to do with their cash reserves. Instead of investing in R&D projects to grow the company, the company is just purchasing back shares to increase EPS.
- Using Borrowed Cash
If a company uses borrowed funds to repurchase shares it can significantly decrease their credit rating. This is a poor way to try and increase shareholder equity. It will negatively impact the stock in the long-term.
- High Reductions in Cash Reserves
A successful share repurchase is done when a company has massive amounts of cash reserves. If they are using ALL or most of their cash reserves to repurchase shares it could negatively affect their profitability in the future. If the reduction in assets stalls growth, then the company’s share price will struggle.
- Avoid Takeover
Sometimes a company will perform a share buyback to avoid a hostile takeover. They will take on a ton of debt to buy back shares. This makes the company less attractive for takeover because it raises share value (makes it more expensive to takeover) and increases the amount of debt on the company’s balance sheet.
As you can see there are good forms of share buybacks and bad forms of share buybacks. When you see news of a buyback you need to evaluate how much cash reserves the company used to repurchase and if they took out any debt. This will give you a better idea if this would be a good move for the company in the future or not.
Homework: Search for 3 company who recently went through a share repurchase program. Analyze their financial statements (10Q) to see how their assets were affected or if they took on any debt to perform the repurchase.