What Are Share Buybacks?

And why they’re important?

Recently we’ve seen some pretty interesting companies take on share buyback campaigns with the likes of:

  • Alibaba recently upped their buyback campaign from $15bn to $25bn.;
  • Microsoft board approved a $60bn share buyback program in 2021; and
  • Meta (facebook) approved a share buyback of $44.8bn in 2021. etc..

So What Exactly Are They? 

A share buyback campaign involves a listed entity buying back its own shares off the stock exchange or from private investors in order to increase its ownership stake in the company. There are a few reasons why an organisation would want to increase its own equity holdings. However, when this does happen, it tends to benefit the common shareholder, here’s why… 

Let’s take a Pie as an example for this, (assuming the pie represent profits for distributions) if an organisation buys back its shares from the stock exchange, then an extra share of the pie goes back to the organisation, and thus, there become fewer outstanding shares. This means that larger slices of the pie will be given out to a smaller amount of stock owners. However, if an entity decides to increase the level of outstanding shares on the stock market, then smaller slices of the pie will be given out(assuming that more people subscribe to the stock) this is known as share dilution. 

Example: Imagine you’re a shareholder of an organisation registered on the stock market, owning 100 shares. The company itself has a total outstanding share count of 1,000,000 shares. This makes you a 0.01% shareholder of the organisation. 

Now, the company buys back 50% of the 1,000,000 outstanding shares. This means that the remaining outstanding shares now stand at 500,000. 

Hence, as a shareholder you now own 0.02% [(100/500,000)*100] of the company as opposed to the previous 0.01% — this essentially means that you have automatically doubled your stake in the company without having to do anything. This is because your slice of the pie (and other investors) has increased in size and fewer ‘slices’ will be given out. 

When Should An Organisation Buy Back Its Shares

Ideally, organisations would ONLY buy back their shares when they have excess cash and have no better alternative to spend it. This is more common with mature companies that have a proven business model and strong barriers safeguarding their interests.

For example, a well-established manufacturing organisation might see it more beneficial to repurchase shares back instead of expanding further and onboarding additional unnecessary risks. It’s an effective way to transfer shareholder value back to the shareholders, as opposed to giving out a dividend.

In the eyes of the organisation it makes absolutely no difference if a company buys back its shares or gives out a dividend. This is because ONLY the excess cash will likely be used. However, if you’re an investor you might want the organisation to opt for the share buyback. 

With share buybacks, the share value of a company increases, and the investor will only be taxed on realised capital gains. With a Dividend, however, the amounts sent for distribution are taxed at the level of the organisations profits, and at the level of the consumers, income tax return meaning, that there is double taxation taking place. 

Why Organisations Buy Back Its Shares

The good… 

Undervalued shares

When an organisation buys back its shares it usually signals that the stock of a company may be undervalued. Like retail investors, the management of a company also loves a good bargain. 

In addition to this, it may also indicate that management is confident in the future operations of the company and believes that there is a good runway for growth ahead of the company. 

In fact, its generally applauded when organisations continually and consistently buy back their shares.  

Improves Financial Ratios

When an organisation buys back its shares it tends to look good on paper, especially when viewing financial ratios and metrics. One of the ratios that is widely used by investors is the earnings per share (EPS) ratio. This signals the amount of earnings an organisation has divided by the number of outstanding shares. If an organisation buys back its shares then the total number of outstanding shares decreases and subsequently makes the EPS more attractive to investors. 

Now, the bad … 

Management May Have Their Own Ambitions

This is specifically the case if the organisations management has bonuses tied to share performance. As we’ve mentioned earlier on, if a company buys back its shares it tends to increase the share price of the company. If however, management have the intention of meeting their individual performance targets to trigger their bonuses, they might intentionally buy back shares without taking much consideration to the actual financial state of the company. Leaving the organisation and investors in a worse-off position than they were in before the buybacks actually took place. 

One way an investor can counter this is to check the organisations liquidity ratios and cash flow statement to ensure that the company has sufficient funds in place to take on the share buyback scheme without impairing operations or financial position. 

In fact in America, banks were actually expelled from the option to buy back shares cause it found that management was acting more on their own personal interests as opposed to the interest of the shareholders of the organisation, and if it’s one thing you should know, is that management are charged with the responsibility of acting on behalf of shareholders and the shareholders main interests. 

To wrap it all up

Share buybacks are a widely understood case scenario, however, human intentions sometimes get in the way of the effectiveness of share buybacks as management may be pursuing their own agenda, as opposed to shareholder interests. 

Generally speaking though, and more often than not, having a share buyback scheme in place is usually applauded by investors for the reasons highlighted above. Make no mistake though, investors need to be on the ball and ensure that the company is in a solid financial position to carry out the campaign as these campaigns are a huge financial commitment.

Stay safe and happy investing!

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Any views or opinions presented in this article are personal and shouldn’t be taken/used as professional advice as we are not qualified financial advisors.
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