The Advantages and Disadvantages of Buyback of Shares
The buyback of shares can happen in any organization, however it is most in the public psyche when it is done by some of the largest and most well-known companies such as Apple, AAPL, as this news makes the mainstream national press.
CNBC cited SP Global, a provider of financial market intelligence, who described Apple/AAPL as "the poster child" for the buyback of shares in January 2022.
We will take a look at why companies, especially huge ones such as Apple/AAPL, Meta and others do this so called stock repurchase, the advantages and disadvantages of buyback of shares and more.
Armed with this knowledge you can then hopefully understand the strategy a company is taking by doing this, and so you can invest accordingly.
What is the Buyback of Shares?
This FAQ about Apple shares on the Apple website is interesting. They have interesting information on their dividends and share buyback programs. The downloadable PDF gives a history of their buyback of shares which is when the company itself buys its shares back on the open market.
In general this is done by the largest and most successful companies in the world, why is that?
If a company makes money these profits are often reinvested back into the company for example by hiring more staff, increasing production, buying more equipment, building more offices/factories or possibly buying rivals or other related companies to help them grow.
Eventually it gets to a point where a company such as Apple/AAPL has bought up most of its rivals, has expanded as much as possible, and it has possibly sold its products such as an iPhone to nearly everyone who wants one!
They are starting to run out of ideas on how to expand, so instead it will return the cash to shareholders, which is not quite the last resort but not far off it.
So almost by definition buyback of shares is done by the largest most successful companies and not a growing company. The thinking being that we might as well use this cash for something instead of letting it sit in the bank, which of course Apple/AAPL still do as they have an infamously large cash pile, over $200billion in February 2022.
What benefits does the buyback of shares have for the company?
Buying shares could be considered as a financial engineering tool. By doing this it will affect certain financial numbers in their statements. Institutional investors, algorithms, and retail investors like you and I, use or at least should use these numbers, to make better financial decisions. Let's look at what it affects:
Total outstanding shares: the number of shares that are available to purchase, i.e. those not held by institutions which buy and hold them over the long term, which is as close to "forever" as you can get.
They are held by people like you and me, who are in general willing to buy or sell shares at any particular time. Share buyback means this number is reduced.
This then has the knock on effect on other important reporting metrics:
EPS: Earnings Per Share. A key metric that is used in quarterly earnings, which get reported on almost every day of the week in market press. It is the earnings for that quarter divided by number of shares which gives you an idea of how profitable the company is.
Seeing earnings per share rise might make you think that the company has increased profits this quarter, therefore the company is doing a lot better.
However if you dig into the figures it might be at least partially caused by the reduction in the number of shares due to a share buyback. So we need to do this investigation ourselves, we can't rely on financial media outlets to do this for us.
Often the buyback of shares is done when the company is doing well and the stock price is high, i.e. buy high. Then in the future when the company is not doing so well the company may need to sell these shares again to raise funds, i.e. sell low. This buy high, sell low is not very smart!.
There are other ways a company can return cash to shareholders:
Pay Cash as a Dividend
Dividends are the probably more well-known and more established as a way to return profits to the business owners and shareholders.
The dividends are paid in cash usually on a per share held basis. The company will set a record date, meaning they make a list all shareholders eligible. Then those shareholders that own shares on the ex-dividend date, usually the day before the record date, will actually receive the dividend. Then the payment will be paid out on the declaration date.
Once a company pays its investors a dividend for the first time, they will then expect to receive them regularly in the future. Also there is significant compliance, organization required and therefore costs when setting up a dividend for the first time, after that it is easier. So it doesn't make sense to set up a dividend for just 1 year.
For this reason, many companies, especially younger ones, opt not to pay out dividends. But older and larger companies pay dividends because they have limited space for growth in the future.
Buy Back of Shares
Buying back shares is another option for distributing cash to stakeholders.
Usually, when a company decides to buy back shares in the open market, only the shareholders who are willing to sell their shares can cash out. When this happens, the percentage ownership stake of each shareholder tends to increase very slightly.
Compared to dividends, the stakeholders don’t expect the repurchase of shares to continue into the future. In this scenario, the company is not pressured to make sudden or regular share buybacks.
The buyback of shares can have positive outcomes or negative consequences. It all depends on the status of the business itself and the initial conditions when the share repurchase is made.
How Buybacks of Shares are Done
There are different means to repurchase shares. The company can buy back shares and record them as treasury shares under assets on the balance sheet or buy all the shares and remove all the outstanding shares in the market.
We go into more detail on using the SEC site to find the amount of Treasury stock or shares Twitter, a public company, had around the time of its takeover by Elon Musk here in how to find out how much a business sold for.
The main methods for repurchasing shares are:
- Repurchasing in the open market: in this method, the company buys back the shares in the open market after a period of time.
- Tendering: Here, the company launches a tender to buy the shares from the current shareholders at a specific price. The share price for repurchase should be higher than the market price of these stocks.
- Dutch Auction Tender: One of the quickest ways to buy back shares is through a share repurchase program via an auction tender. Compared to tendering where the share prices are fixed, in Dutch auction tender, the company establishes a price range. It is a throwback to the 17th Century when traders used this strategy in the Dutch Tulip Market.
- Buyback Through Direct Negotiation: In this method, the company goes directly to the shareholders who have shares it wants to buy. The representative directly negotiates for a premium price, beyond the current share prices.
Share buybacks are a relatively new idea, and they are gradually becoming more common and the SEC have acknowledged that the whole process needs to become more transparent.
Back in December 2021 the SEC made this announcement which would require "an issuer to provide a new Form SR before the end of the first business day following the day the issuer executes a share repurchase." This new reporting will be beneficial to us all.
The Advantages of Buyback of Shares
- Boost in share prices: An obvious benefit from the buyback of shares is an increase in the share prices. With the buyback, it means that there are fewer shares trading in the markets. So with basic supply and demand the increased demand tends to raise the share prices, if only for a short time.
- Better earnings per share: As explained above, a publicly traded company tracks its progress by looking at the earnings per share(EPS). When there are fewer shares trading, the EPS number tends to rise. It can help the company meet the market’s expectations and drive higher stock prices.
- Rising dividends: Sometimes a company can increase the dividend payment after a buyback since there are fewer shareholders for the company to pay.
- Positive Market Sentiment: When a company buys back stocks, and the price rises this can increase positive market sentiment and possibly see a rally where the stock rises even further.
- Less Excess Cash: The interest rate can be very low on cash and in general investors prefer to see a company doing something with its cash reserves.
The Disadvantages of Buyback of Shares
- Poor Predictions: As explained above there is a chance that companies may end up buying their stocks at high levels, making the buyback a bad use of capital.
- Poor Use of Capital: You can argue that the buyback of shares is not the best use of cpaital a company has.
- Reducing Dividends: Another disadvantage of buying shares is that after the company repurchases shares, it will have reduced funds for dividends. That can be bad news for investors.
- Management Self-Interest: Stock buybacks can be more beneficial to big shareholders, which are often the company executives. The temporary boost in share prices can be viewed as self-serving as they can quickly resell these stocks and earn an instant profit.
- Cover for Stock Handouts: If the company is giving stock options to its managers or other staff, the buyback of shares can cover this by reducing the number of shares on the market.
Conclusion
Stock repurchase or the buying back of shares can be a great move by companies to get control over the business. Though it has its share of pros and cons.
Assessing whether the positive aspects of the buyback can outweigh the negative ones can be tricky. But, at the end of the day, the decision lies in the hands of the shareholders whether to proceed or not. In terms of tax benefits the buyback of shares can provide many benefits.
You might be also interested in Buy When There’s Blood In The Streets and What is an Investor Day?
