A share buyback refers to a process where a company initiates the purchase of its shares thus reducing the outstanding shares in the open market. Also referred to as repurchase, it is a program whereby a company purchases its shares from the marketplace since the management has found out that the shares are undervalued.
The program also allows the company to purchase its shares directly from the marketplace or they may offer their shareholders an opportunity of selling their shares back to the company at a fixed price. As a result, the company is able to increase its earnings per share thus elevating its market value for the remaining shares.
Once the purchase is complete, the shares are usually cancelled or held as treasury shares. This is because they can no longer be traded on the open market.
How A Share Buyback Works
There are two methods which can be implemented by a company.
Method One – Shareholders are presented with a tender offer by the company. As a result, they will now have a chance of submitting or tendering a portion or all of their shares. This transaction should be completed within a given time period.
The tendering offer is usually provided at a premium rate in comparison to the market price. Thanks to the premium rate, shareholders are compensated for selling their shares back to the company.
Method Two – In this method, a company will opt to purchase its shares directly from the marketplace. This will happen over an extended period. The purchase is initiated by an outlined share repurchase program which stipulates that shares can be bought from the marketplace at specific duration’s or at regular intervals.
In order for a company to complete this type of transaction, they will take on debt together with cash on hand or from its cash flow.
Reasons Why Companies Repurchase Stock
There are few different reasons why a company would buyback stock. Below we’ll go over each reason in detail.
Reduce The Overall Cost Of Capital – You already know that shares represent a portion or stake in the ownership of a company. A company will always sell shares to investors with the goal of acquiring funds in order to expand. When there are no opportunities for growth, it means the shareholders will be holding unused equity funding which translates to sharing ownership with no benefit. By buying back its shares, the company helps to reduce the cost of capital.
Take Advantage Of Undervaluation – There are several reasons why the stock of a company may be undervalued. Some of them include the company may have diversified away from its core high return business, the company has not paid or has cut back on dividends or it’s too complex. If this happens, the company may opt to buyback its shares at a lower price and re-issue them once the market has improved.
To Make The Company Appear Attractive To Investors – When the number of outstanding shares is reduced, the company’s earnings per share ratio is increased automatically. As a result, short term traders will invest in the company in order to make quick profits. What you need to know is that this may also happen before the buyback. Due to the influx of investors, the stock’s price will rise boosting the company’s price to earnings ratio.
You may be wondering if a buyback is good or bad for the company. Well, this depends on the current situation. If the company is undervalued and a buyback helps to make it attractive or improve its market value, then it is a good decision to make. In case the company is using share buyback to prop up ratios and also to provide short-term relief to its share price, then it could result in disaster.