What is Share Buyback?
A share buyback is a transaction in which a company buys back its own shares from the open market. Another term for it is share repurchase. There are various methods to buy back shares. The company can buy back the shares from the market or tender offer. The shares bought back will be reclassified as treasury shares, or they will be canceled depending on the purpose.
Share Buyback Example
Let’s take an example to understand the effect of buyback on financial statements:
- Company X has 4 million shares outstanding, and it announces the buyback of 1 million shares.
- The par value of the stock is $ 10 per share, and its issue price is $ 17 per share.
- The stock is currently trading at $ 15 per share.
|Description||Before Buyback||After Buyback|
|Cost Method||Par Value Method|
|No. of shares outstanding||4,000,000||3,000,000||3,000,000|
|Equity share capital(Par value: $10, Issued at $17)||40,000,000||40,000,000||40,000,000|
|Additional paid up equity||28,000,000||28,000,000||21,000,000|
|Treasury stock value**||0||(15,000,000)||(10,000,000)|
|Additional paid-in capital : Treasury stock||0||0||2,000,000|
|Other Components (Reserves)||10,000,000||10,000,000||10,000,000|
(Note** Treasury shares are the shares that are repurchased but not retired or canceled. They are kept in the treasury. Such shares will not be entitled to receive dividends and voting rights as they are not considered part of outstanding shares.)
There are two methods for treating treasury shares.
Under this method, cash is reduced on the asset side by the amount paid. The cash required to buy shares from the market would be 15 million (1 million shares * $ 15). The number of shares outstanding will reduce to 3 million, while the treasury stock with the company will be 1 million. The stock holder’s equity will be directly reduced by the cost of treasury stock, which is also 15 million. Net income will be unaffected.
Par Value Method
In this method, cash on the asset side will be reduced by 15 million. However, treasury stock is treated differently. Treasury stock value is calculated at par value rather than at cost, i.e., $ 10 million (1 million shares * $ 10). It is deducted from equity.
The company issued a $10 par value stock at $17. So, the premium of 7 million (1 million * $(17-10)) needs to be reversed/deducted from the additional paid-in capital. Here, the company issued the stock at $17 and bought it back at $15. So the loss of 2 million (1 million * $(17-15)) is shown as “Additional Paid-in Capital: Treasury Stock.” The loss will be deducted from treasury stock or added to the equity.
The net effect on the asset and equity side is the same in both methods.
Purposes of Share Buyback
Distribution of Extra Cash
The share buyback is used as a mechanism to distribute the excess cash available with the company. This extra cash might have got accumulated as a result of a lack of attractive reinvestment opportunities in the near future. The company may not want to disrupt its stable cash dividend schedule for distributing such extra cash. So for such an occasional event, the company distributes this extra cash to shareholders through the buyback. Hence this also acts as a type of dividend. Shareholders will be able to create more value by investing that money anywhere else.
Support the Stock Undervaluation
When the management perceives their share prices are undervalued, they support the price through share repurchase. The reasons for undervaluation could be sentiments like investors overreacting to bad news, investors’ inability to see future growth prospects, investors giving too much importance to short-term performance, poor economy, etc. Share buyback sends a positive signal as the company invests in its own shares because it is optimistic about its own future prospects. For example, a company’s stock price fell to $30 after bad news. The company feels this is just an overreaction, so it buys back some shares. When the price reaches its intrinsic value, the company may sell the bought back shares and generate profit.
Boosting Financial Ratio
The company might undertake share buyback to boost financial ratios. We have calculated some ratios to see the effect.
TABLE 2: (Refer to Table 1 along with this)
|Description||Without Buyback||With Buyback|
|Earnings per share = Net income / Number of shares||3 million / 4 million||3 million / 3 million|
|$ 0.75 per share||$ 1 per share|
|Return on Asset (ROA) =Net Income/ Total Assets||3 million / 90 million||3 million / 75 million|
|Return on Equity (ROE) = Net income/Total Equity||3 million / 78 million||3 million / 63 million|
|Stock Price||$ 15 per share||Driven by Market|
|P/E Ratio||20||Dependent on Stock Price|
As you can see, earnings per share (EPS) increases to $1 per share from 0.75 per share. The profitability of the company has not changed. This growth in EPS is a result of the reduction in outstanding shares. Similarly, the buyback is making ROE and ROA look better.
Theoretically, the market share prices rise after its buyback. In theory, it is assumed that the P/E ratio will remain the same at $ 20 after the buyback. So, the expected market price after repurchase should be $ 20 (P/E ratio * EPS = $ 20 * $ 1 per Share). In practical life, the price is driven by market sentiments. So the price can be less than or more than 20. The P/E ratio will decrease if the price is less than 20 and vice versa.
Many companies issue convertible securities and stock options. When these stock options are exercised, new shares need to be issued. Issuing new shares would dilute the percentage ownership of existing shareholders. So, rather than issuing new shares, re-issuing the treasury shares that were repurchased earlier helps manage the dilution of the ownership stake.
Changing Capital Structure
Some companies take leverage to repurchase the shares. The purpose of this leverage buyback is to make changes in capital structure. It will increase the debt and decrease the equity, so the debt to equity ratio will increase. Due to these changes, the weighted average cost of capital (WACC) will come down.
Avoid Hostile Takeovers
The company is buying back shares from the free float in a buyback. The insiders (i.e., promoters, directors, or senior officer) will hold their stock, and their percentage of holding will increase. Through this action, they will be able to defend against the hostile takeover.