Stock buybacks are a controversial topic in the world of value investing. Some investors view them as waste of capital, while others view them as an effective way to create shareholder value. Companies can issue a stock buyback for different reasons. If done correctly they can create immense value and opportunity for shareholders.
Summary
- When a company announces a stock buyback they repurchase shares of their own stock from investors
- Some of the different types of stock buybacks include: open market, fixed price tender offer, Dutch auction tender offers, direct negotiations
- Stock buybacks are an alternative way of providing value for investors
- Buybacks reduce the number of shares outstanding
Stock Buybacks Explained
A stock buyback, also referred to as share repurchase is when a company declares that it will repurchase shares of its own stock. Instead of distributing dividends to investors, companies can choose to buy back their own shares to generate value for shareholders. It can be a more flexible way of providing value and redistributing money back to investors.
A company can repurchase its own shares of stock by distributing cash to its existing shareholders in exchange for the company’s outstanding equity. The stock buyback allows companies to acquire a portion of their own stock that was previously distributed to public investors.
The cash exchanged for the shares reduces the number of shares outstanding. From here, the company has the option of retiring the repurchased shares or keep them as treasury stock. These shares can be reissued to the public at a future date.
Different Types of Stock Buybacks
There are four major types of stock repurchase plans. They include open market buybacks, fixed priced tender offers, Dutch auction tender offers, and direct negotiations. It’s estimated that 95% of buybacks are executed through the open market.
Open Market Buyback
This is the most common type of buyback. With this type of buyback a company purchases its share back directly from the market through the company’s brokers. When an open-market buyback is made public, the repurchase process can take a few months to a few years. It’s worth noting that SEC has daily buyback limits in place which restrict the amount of stock a company can buy back in a given time frame.
SEC rule 10b-18 states that a company cannot purchase more than 25% of the average daily volume. Open market buybacks have an impact on the share price because they reduce the number of shares outstanding.
The main advantage to using an open market buyback plan is because it’s cost-effective. Shares are bought directly at the current market price and not at a premium like other plans.
Fixed Price Tender Offer
A fixed price tender offer is a bid to purchase a certain amount of shares from shareholders at a fixed price. Tender offers are usually made publicly and give all shareholders the option to sell their shares for a specified price within a pre-determined time frame.
The price investors are given with a tender offer is usually at a premium to the current market price. This premium is used as an incentive for investors to sell their shares. There are also contingencies in place, such as holding a minimum or a maximum number of shares in order to be able to participate.
For example, a tender offer might be made to purchase outstanding shares for $30 a share when the current market price of the stock is $25 per share. This represents a $5 premium above the current market price.
Dutch Auction Tender Offer
With a Dutch auction buyback, a company will make an offer to shareholders to purchase shares back within a range of different price points at a premium above the current market price. After that, shareholders will submit their bids by outlining the number of shares they are willing to sell and the minimum price at which they are willing to sell their shares.
The company will then review the bids and aggregate the prices and decide at which price point to buy back the shares from investors.
This type of buyback plan rarely happens nowadays as it can be complicated, time consuming, and requires a lot of effort to coordinate.
Direct Negotiations
In a direction negotiation buyback, a company will deal directly with large institutions or individual investors to buy back the company shares. They will not offer the buyback to the general public. In a direct negotiation, the company will buy the shares at some sort or premium.
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A key benefit with this type of buyback is that the negotiation is straightforward and direct with a single institution or small batch of investors. This can be a very cost-effective buyback method because you can strike a very good deal with institutions and shareholders.
Important: The U.S. Securities and Exchange Commission (SEC) rule 10b-18[1] establishes the requirements and stipulations for stock repurchases in the US.
Why Companies Buy Back Shares
Some of the most common reasons that companies engage in share repurchases include the following:
1. Company Believes it’s Stock is Undervalued
If a company analyzes their financial state and decides that their stock is undervalued, they may be motivated to buy back it’s shares in order to further boosts its share price. You can see a list of stock buy back announcements at MarketBeat.com.
2. Take Advantages of Tax Benefits
Share buybacks are a great alternative to distributing dividends to shareholders. It’s a great option in which the capital gains tax is much lower than the dividend tax rate. If you’re a large business which happens to own a large position in a specific stock, it may be more beneficial for you to be a part of stock buyback instead of receiving dividends.
3. Distribute Capital to Shareholders In a Flexible Way
Stock buybacks give a company flexibility in how they will execute the buyback plan. When compared to distributing dividends, stock buybacks don’t have have to follow a certain repurchase dates or predetermined amounts they will be buying. Dividends are very straightforward and don’t give management flexibility in managing the cash distribution to shareholders.
4. To Combat Hostile Takeovers
Another lesser talked about reason why companies can chose to repurchase their own shares is to avoid hostile takeovers. Share buybacks reduce the amount of shares outstanding available to the public. As a result, they can function as a method by companies to prevent other companies from gaining majority control.
Advantages and Disadvantages of Share Buybacks
While share buybacks can act as a great alternative to distributing dividends, they have their own set of advantages and disadvantages.
Advantages
- It can be a more flexible and effective way of improving shareholder value
- Shows a positive signal for investors
- Management can take advantage of their stock being undervalued and boost shareholder value
Disadvantages
- Can be a signal that a specific stock has topped out and companies will buy shares back to artificially boost the price up
- Share buybacks can create a false signal that company earnings are increasing
- Stock price increase as a result of share buybacks can benefit short term investors but hurt long term investors
FAQ’s
Do Share Repurchases Decrease Shareholder Equity?
On a balance sheet, share repurchase decreases the company’s cash holdings. They also reduce the total assets by the amount of cash announced in the buyback plan. By reducing the supply of shares in the market, share buybacks tend to push the stock price up.
How do Share Repurchases Affect Book Value of Equity
Share buybacks increase the earnings per share but reduce the book value per share.
Article Sources
[1] U.S. Securities and Exchange Commission Rule 10b-18: Issuer Repurchases – https://www.sec.gov/divisions/marketreg/repurchases.shtml
