In the current market, we see so many companies buying back stocks of their own company. As investors it is wise for us to know what all things mean because they will all have an impact on our portfolio. The article below will discuss what a buyback is, how it is done and give an example of a buyback scenario.
What is a ‘Buyback’
A buyback, also known as a repurchase, is the purchase by a company of its outstanding shares that reduces the number of its shares on the open market. Companies buy back shares for a number of reasons, such as to increase the value of shares still available by reducing the supply of them or eliminate any threats by shareholders who may be looking for a controlling stake.
BREAKING DOWN ‘Buyback’
A buyback allows companies to invest in themselves. By reducing the number of shares outstanding on the market, buybacks increase the proportion of shares owned by enduring investors. A company may feel its shares are undervalued and buy them back to provide investors with a return, and because the company is bullish on its current operations. A buyback also boosts the proportional share of earnings a share is allocated; all else equal, this boosts the valuation of a stock even if it maintains the same price-to-earnings (P/E) ratio.
Another reason for a buyback is for compensation purposes. Companies often award their employees and management with stock rewards and stock options; to make due on the shares and options, companies buy back shares and issue them to employees and management. This helps to avoid the dilution of existing shareholders. Activist investors can also argue for buybacks when a company’s stock has not performed in line with the greater market or its industry.
How Companies Perform a Buyback
Buybacks can be carried out in two ways:
1. Shareholders may be presented with a tender offer where they have the option to submit, or tender, a portion of or all of their shares within a certain timeframe and at a premium to the current market price. This premium compensates investors for tendering their shares rather than holding on to them.
2. Companies buy back shares on the open market over an extended period of time and may even have an outlined share repurchase program that buys back shares at certain times or at regular intervals.
A company can fund its buyback by taking on debt, with cash on hand or with its cash flow from operations.
Example of a Buyback
A company’s stock has underperformed its competitors’ stocks even though it has had a relatively good financial year. To please long-term investors and provide a return to them, it announces a new share buyback program that will repurchase 10% of its outstanding shares at the current market price. The company had $1 million in earnings spread out over 1 million shares, equating to EPS of $1.00. With a P/E of 20, the shares traded at $20. All else equal, 100,000 shares would be repurchased and the new EPS would be $1.11, or $1 million in earnings spread out over 900,000 shares. At a P/E of 20, the shares would trade up 11% to $22.22.