What are share buybacks?
And why do companies do them?
If you read the financial press then every once in a while you’ll see that a company has bought back some of its own shares.
Take Barclays. Until COVID-19 struck, the UK bank had planned on buying back a billion pound’s worth of its own shares.
On the face of it, this may seem like a strange thing to do. After all, a business usually issues shares so that it can raise money from investors. So why sell them back?
Like so many things related to investing, this question seems simple but actually leads down a rabbit hole full of intrigue, supply-and-demand theory and risks and rewards.
Return to shareholder
One of the key goals that a publicly listed company has is to provide a return on investment to its shareholders.
It might do this by paying them dividends. These are payments that some businesses will make to investors for holding their shares.
Like dividends, share buybacks are another way of giving shareholders a return on their investment.
Ultimately, most investors hold shares because they want to trade them for cash, which they can then use in their daily lives. Paying dividends is one way of getting this money but selling shares back to a company is another.
This process can actually end up saving companies money in the long run. That may sound counterintuitive but if a firm has a huge number of shareholders, it’s going to have to pay out a huge amount in dividends. By reducing the number of shares in the market, a company can lower the amount it has to pay to shareholders in the form of dividends.
Better finances
For companies, buying back shares also has the positive side-effect of making their finances look better.
Earnings per share (EPS) is a phrase that you’ll often hear in the investment world. In really simple terms, it refers to how much money a firm makes relative to its number of shares.
You calculate EPS by dividing a company’s earnings by its total number of shares. That means a company can boost its EPS by reducing the number of shares it has in the market.
If that sounds a little too theoretical then imagine a company that has earnings of £1 billion and 1 billion outstanding shares. We calculate the company’s EPS by taking its earnings (£1 billion) and dividing them by the number of shares (1 billion). That means EPS will equal £1.
Now imagine this same company buys back 500 million shares. It still has earnings of £1 billion but it will ‘only’ have 500 million outstanding shares. That will mean its EPS doubles to £2.
This could, on paper, make the company seem more attractive to investors. The problem is that many of them will have seen the share buyback and understand why the EPS increased.
As such, increasing EPS is more likely to be a positive byproduct of a buyback for a company, rather than being the driving force behind its decision to undertake it.
Dilution
Aside from providing a return to investors or boosting financial statements, share buybacks can also be a means of preventing a company’s shares from being diluted.
Over time, a company may issue more shares to raise extra capital. They might also provide their employees with stock options, which ultimately leads to more shares being issued.
This leads to that old problem of supply and demand. If the demand for a company’s shares remains the same but there are an increasing number of shares, then those shares will decrease in value.
This might annoy shareholders but it will also mean that the company’s financials start to look bad. Unlike the example above, where a decrease in the number of shares boosts EPS, dilution — the creation of more and more shares — would shrink EPS. Buying back shares and cancelling them can stop this from happening.
Buy low, sell high
The thing is, a company doesn’t have to cancel shares it buys back. Instead, it can hold on to them and then sell them again at a later point.
As you can probably imagine, a company would be more likely to do this for the same reason that a regular investor would — they think their shares are undervalued and that they’ll increase in price in the future.
The benefit of this is not just that it has the potential to make a firm some money. It’s also a positive sign for investors.
If they believe that a company is buying back shares with a view to selling them again in the future, it could indicate that the business is doing well. In turn, that may make them decide to invest in the company.
Incidentally, it’s not uncommon for senior executives at a company to buy shares as a way of demonstrating to investors that they have confidence in the business going forward.
What does it mean for investors?
Like many things in the stock market, share buybacks can have a butterfly effect, where one small action ends up impacting a number of different things.
What may look like a simple step taken to provide a return to investors could actually be a way of reducing future dividend payments and cutting costs for a company.
Buybacks could also improve a company’s EPS metrics. But it’s far from certain that this would translate into positive outcomes for shareholders or investors that decide to put money into a business after any share repurchases take place.
With all of that in mind, just remember that there’s more to a buyback than a company snapping up some shares. Next time you see one that is happening, dig a little deeper and you’ll probably get sucked down one of those incredible investing rabbit holes.
When you invest, your capital is at risk. The value of your portfolio can go down as well as up and you may get back less than you invest.
This should not be read as personal investment advice and individual investors should make their own decisions or seek independent advice. This article has not been prepared in accordance with legal requirements designed to promote the independence of investment research and is considered a marketing communication.
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