What Is A Share Buyback? – Forbes Advisor UK

With some companies holding huge cash reserves, share buybacks have grown in popularity as a means of returning cash to shareholders.

AJ Bell reports that FTSE 100 companies are on track to set a new record for share repurchases, with £37bn announced by early May. This comfortably tops the previous high of £35bn in 2018.

Even American tech companies, which have traditionally reinvested excess cash to secure future growth, have joined the trend. Over the past decade, Apple has spent nearly $500 billion on share buybacks, as have Alphabet and Amazon, according to CNBC.

Let’s take a closer look at why companies buy back their shares and the potential benefits for shareholders.

How does share buyback work?

Buybacks or share buybacks occur when a public company uses cash to buy its own shares in the open market. Share buybacks are open to all shareholders, but there is no obligation to sell shares.

The company requires shareholder approval to buy back shares, which is usually given at the annual general meeting. This authorization will specify the maximum value or number of shares to be redeemed.

A less common form of share buyback is a tender offer, where shareholders are invited to put up for sale some or all of their shares at a fixed or variable price. Tender offers are usually only used to buy back more value.

Why do companies buy back their shares?

Share buybacks are an alternative to share dividends (usually paid twice a year) as a means of returning cash to shareholders. In theory, share buybacks should create value for shareholders if they increase the share price (which we will explain in more detail later).

While dividends are attractive to income-seeking investors, share buybacks have some advantages:

• Increase in share price: this is the main purpose of share repurchases, as rising demand and shrinking supply should, in theory, push the price up. The board of directors may decide it’s time to buy back the shares if it thinks the company is undervalued, especially in a bear market. Investors may view the buyback as a sign of confidence as the company expects its share price to rise.
• Flexibility for the company: A company’s dividend policy is seen as a barometer of its future earnings, and as a result, companies are reluctant to cut dividends. Dividend cuts could also encourage income-seeking investors to sell their shares, putting further downward pressure on the share price. Share buybacks are more flexible as they can be stopped and resumed without triggering negative sentiment.
• Possible tax benefits: dividends are taxed as income, while any gains from rising stock prices are taxed as capital gains. This can provide flexibility for shareholders to time their shares to take advantage of any discounts or capital losses to reduce their capital gains tax liability.
• To balance dilution: companies often offer stock options to attract and retain employees. Over time, this increases the number of issued shares and dilutes existing shareholders. Share buybacks help offset this dilution.

How does a share buyback affect a company’s valuation?

Companies usually cancel redeemed shares (although they may be retained and reissued or transferred to employees). This reduces the number of shares outstanding, which has an indirect effect on the key valuation metrics used by investors.

Let’s look at an example. The company has a profit of £100 million and has 100 million shares. Earnings per share (EPS) is calculated by dividing earnings by the number of shares, in this case £100 million divided by 100 million, which gives an earnings per share of £1.

If the company buys back 10 million shares, its earnings per share will now be £100 million divided by 90 million shares, which is £1.11. As a result, earnings per share rose from £1 to £1.11, which should have a positive impact on demand for shares.

While this works in theory, caution is required. Investors will also pay attention to underlying earnings, and a drop in earnings will affect the share price, regardless of EPS. In addition, the return of cash to shareholders may affect the company’s future earnings if it could be reinvested to stimulate earnings growth.

Biggest share buybacks in 2022

Not surprisingly, BP and Shell top the list of share buybacks, generating significant cash flow from record commodity prices. FTSE 100 heavyweights Aviva, Unilever and British American Tobacco also made the top five after strong financial performance.

What are the disadvantages of share buybacks?

Despite the benefits of share buybacks, there are potential downsides:

• Misuse of cash: Share buybacks may result in a short-term increase in the share price at the expense of future growth. Investing in research and development, acquisitions, or building cash reserves as a hedge against an economic downturn can lead to a higher share price in the long run.
• Debt financing: Before the pandemic, some companies funded share buybacks with debt rather than cash, also known as leveraged buyouts. While the debt could be available at low interest rates, this could be a short-sighted strategy as the debt must be repaid and this could affect the company’s credit rating.
• Impact on shareholders: shareholders may prefer to receive additional cash in the form of dividends for tax reasons or because dividends are a more reliable source of income. Companies can return excess cash to shareholders in the form of “special” or one-time dividends.
• Impact on share-based compensation: Because share buybacks offset new shares issued to employees, it can be harder for investors to see how many shares have been issued by employee schemes. Performance-based compensation schemes are also often based on metrics such as earnings per share. Share buybacks may result in the achievement of earnings per share and reward targets, which might not have been the case without the buyback.

What does a share buyback mean to you?

A share buyback program is usually positive for shareholders because it means the company is performing well and generating high levels of cash. In the short term, share buybacks often have a positive impact on a company’s share price, and shareholders can choose whether to participate in the buyback.

However, if the excess cash is better reinvested in the business to enter new products or markets, this could affect the company’s future value and share price.

A share buyback program is a good opportunity for investors to consider whether other companies can offer higher upside potential for their future share price. You may find it useful to compare the current share price with brokers’ share price predictions for the next 12 months.