By Dada Adefolami
A share buyback occurs when a business purchases its own shares and then either cancels them or holds them in treasury for re-issue at a later date. A buyback is the repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies will buy back shares either to increase the value of shares still available (reducing supply), or to eliminate any threats by shareholders who may be looking for a controlling stake
To implement a buyback, a business may acquire its shares in the open market in much the same way as any other investor. It may, however, makea proportional offer, where a set proportion from each investor is purchased, or a universal tender offer, where a fixed number of shares is acquired at a particular price.
The law normally requires public companies to buy back shares from funds generated either from distributable profits or from the proceeds of a fresh issue of shares.
A company can fail because of a shortage of cash even while profitable. as an alternative measure of a business’s profits when it is believed that accrual accounting concepts do not represent economic realities. For instance, a company may be notionally profitable but generating little operational cash. In such a case, the company may be deriving additional operating cash by issuing shares or raising additional debt finance
One interpretation of a buyback is that the company is financially healthy and no longer needs excess equity funding. Businesses that have expanded to dominate their industries, for example, may find that there is little more growth to be had. With so little headroom left to grow into, carrying large amounts of equity capital on the balance sheet becomes more of a burden than a blessing. Large companies may choose to repurchase all or part of their original stock issuance to reduce their total assets, thereby increasing several financial metrics that compare profitability to equity or the number of shares outstanding. The return on equity (ROE) ratio is a good example of an important financial metric that receives an automatic boost when the equity figure is minimized
Buybacks can be undertaken either on an intensive basis or over a period of time. A recent example of the latter is when Microsoft Corporation announced, in September 2008, its intention to buy back $40bn worth of its own shares over a five-year period.
BUYBACKS VERSUS DIVIDENDS
Share buybacks offer an alternative to dividend payments as a means of returning funds to investors. This raises the question as to which of the two methods investors prefer. If we assume perfect capital markets, they will be indifferent. A simple example makes this point clear.
illustration
XYZ plc has one million shares in issue, and surplus cash of N2m which is to be distributed to investors. Following this distribution, profits are expected to be N1m per year, and the price/earnings ratio is expected to be eight times.
The distribution will be made by either: illustration
1. a dividend of N2 per share, or
2. a tender offer of 200,000 shares at N10 per share.
Whichever distribution method is chosen, the total market value (TMV) of the shares will be the same, as the risks will be unaffected by the choice of method. TMV can be calculated as follows:
TMV = profit x P/E ratio = N1m x 8 = N8m.
Under the dividend option, however, there will be one million shares in issue, and under the buyback option there will be 800,000 shares in issue. This means that the value per share will be N8 (N8m/1m) under the dividend option and N10 (N8m/800,000) under the buyback option.
Now consider the situation of a shareholder with 10,000 shares under both the dividend option and the buyback option, where there is a choice of either holding or selling the shares.
We can see that the total wealth is the same under each option and so the investor should be indifferent as to which option is chosen. This is comparable to the Miller and Modigliani proposition concerning the indifference of investors towards dividends and capital gains.
The above analysis rests on the assumptions underpinning perfect capital markets, such as no transaction costs, similar tax treatments, and so on. In our world of imperfect capital markets, however, there are two important reasons why a share buyback may be preferred:
Flexibility
Where a business has surplus funds to return to investors, managers will view dividends differently to share buybacks. Various studies have shown that managers usually feel committed to maintaining a sustainable level of dividend payments. This means they are unlikely to respond to a temporary cash surplus by increasing dividends, which will then have to be decreased in subsequent periods. Share buybacks, on the other hand, tend to be regarded as a residual. Thus, where there is surplus cash to be distributed, a buyback is likely to be viewed as the more appealing option.
Postponing, a share buyback programme does not incur the kind of adverse reaction from investors that would normally accompany a cut in dividends. For this reason, perhaps, managers do not always display the same commitment to implementing buyback programmes as they do to paying dividends. The particular method of share buyback employed, however, will influence the level of commitment that must be made. Where a programme of open market purchases over a period of time is adopted, managers have considerable discretion over the timing and amount of shares purchased. There is much less discretion, however, where a tender offer or proportional offer is adopted.
Taxation
Share buybacks can be a more tax-efficient method of returning funds to investors. Any gains arising from the sale of shares will be subject to capital gains tax. In some countries, the taxation rules treat capital gains differently to dividends. for example, capital gains below a certain threshold are not taxable, whereas all dividends are taxable. Thus, investors may prefer to receive funds from the business in the form of capital gains. Furthermore, it is possible for an investor to exert some control over the timing of capital gains by choosing when to sell shares, whereas the timing of dividends normally rests with the managers of the business. If buybacks are made on a regular and frequent basis, however, the tax authorities may conclude that their purpose is simply to avoid taxation: this runs the risk that they will be treated for tax purposes as dividends.
WHY DO BUSINESSES BUY BACK THEIR SHARES?
Various reasons have been put forward to explain why managers have increasingly relied on buybacks to return funds to investors. These include:
Undervalued shares
Where share values are temporarily depressed, open market purchases will benefit investors who continue to hold their shares. In effect, the purchase of shares below their intrinsic value will transfer wealth from those investors that sell to those that continue to hold. Critics argue that this is unfair to the investors that sell. Instead, a proportional offer, or tender offer, where shares are purchased at a premium to their current value, would provide a more equitable way to return funds. If, however, the market recognizes that open market purchases are being undertaken because shares are undervalued, share prices are likely to rise quickly. Assuming they rise to their intrinsic values, the real wealth of investors that continue to hold will not be increased, although it will now be reflected in the market value of the shares.
Market signaling
In an imperfect world, managers have access to information that investors do not have. If managers believe that the market undervalues the business, they may send a signal to the market concerning this fact. Whereas investors may discount bullish statements and favorable predictions, concrete actions such as share buybacks or increased dividends are likely to be taken more seriously. Various studies have shown that the market responds positively to news of a share buyback, and some suggest that this is due to the information effects
A share buyback announcement may, however, send an ambiguous signal to investors, as not all buybacks will reflect the managers’ belief that the shares are undervalued. There may be other non-value enhancing motives. Details of a proposed buyback will therefore be scrutinized by investors to see whether it can be interpreted as a signal that the shares are undervalued. Thus, for example, a decision by managers to hold on to their shares in the business, and a decision to buy back a large proportion of shares, may both be viewed as a positive sign.
Alter the capital structure
A business may increase its level of gearing in order to achieve an optimal financial structure. By embarking on a share buyback programme, the capital structure of a business can be shifted in favour of debt. Because of the tax shield effects, this can lower the cost of capital. the top 200 UK business the finance directors confirmed that achieving an optimal capital structure was the main reason cited for undertaking share buybacks
Such business using a share buyback to change its capital structure is Siemens, the large engineering and technology business. In November 2007, it announced an intention to optimise its capital structure and simultaneously announced a share repurchase programme of up to €10bn to achieve this. The new capital structure will is in place by 2010.
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