Stock Buybacks: Why Do Companies Buy Back Shares?

In recent years, buyback programs have become one of the growth drivers of U.S. stock markets, creating demand and reducing supply. Corporations have proved to be quite prominent buyers on stock exchanges, and the number of shares outstanding has declined. The year 2021 was no exception. Thanks to the growth of buyback programs, U.S. stock markets were able to reach record highs. Since the beginning of last year, the S&P 500 rose 25% and broke its records 67 times. In the third quarter of 2021, for example, companies on the index list bought back $234.5 billion worth of stock, breaking the previous record of $223 billion for the fourth quarter of 2018.

Today we will learn more about stock buybacks, what makes companies repurchase their shares, and will find out what it means for investors.

What is a Stock Buyback and How Does it Happen?

A buyback is a stock buyback. A company buys back securities from shareholders and actually takes some of its shares out of circulation on the stock market.

More often than not, corporations announce a buyback when they have accumulated free cash that is not used for investments in the company's development. A buyback allows to increase the actual shares of the largest shareholders and strengthen their positions.

Moreover, under the conditions of strong competition, if a large company has enough free funds, but has no new directions for development and for the investment of its capital, investors may consider it a sign of business stagnation and start to sell shares.

The cheaper the stock, the easier it is to repurchase significant shares in the company. This creates the risk of a change of ownership or takeover. To prevent this, company management resorts to repurchasing its shares from shareholders - the demand for securities created by the company during buyback and the subsequent reduction of shares in circulation move the quotes up, and consequently, increase the value of the company.

Reasons for Buybacks

The management of a company may buy back shares from the market in order not to hold large amounts of cash in their accounts. In the case of large companies, buybacks are used to invest free cash in their own stock in order to sell it later at a higher price. News that an issuer has invested in its own stock means that the company has confidence in its own future. Such confidence creates additional demand for the stock, which causes its price to rise. After a while, big investors sell their shares at higher prices and benefit  from them. Buybacks are also carried out if a company's shares are severely undervalued. Buyback of shares from the market raises their prices. An important reason for buybacks is the decision to share gains with investors. The company buys back the shares from the holders with the condition of obligatory redemption. As a rule, in this case, the purchase price of the share is attractive to investors.

Another reason for repurchasing shares from the market is the desire of top management to transfer a portion of the stock to the company's employees. This gives more motivation to the staff, as well as reduces the risk of losing control over the company.

The reasons for a buyback may be more private goals. For example, it saves the company capital on dividends and thus on taxes. Since part of the free funds, which is net returns, is used to buy its own shares, fewer dividends will have to be paid.

Ways of Conducting a Buyback

The issuing company conducts share buybacks in several ways.

Buyback from the open market. This method is the simplest and most frequent. The company publishes an announcement on its website about the start of a share buyback program, which specifies the timing and amount to be spent on the buyback. The issuer then puts bids on the stock exchange to buy the shares. The bids may be placed on one stock exchange or on several, depending on where the company's shares are traded. The companies are not required to specify the volume and price of the shares in their bids. Buyback from the open market is most popular on American and European exchanges.

Buyback directly from investors. In the case of buyback of shares directly from investors, a tender is held, in which the company buys shares from shareholders at a certain fixed price. As a rule, this price is higher than the market price. Unlike the previous method, the tender repurchase of shares leads to the withdrawal of a large number of shares in a short period of time.

Conducting a "Dutch" auction. A distinctive feature of this method of the share buyback is the unpredictability of its outcome for investors. The "Dutch" auction presupposes that the issuer puts the minimum and the maximum purchase price of shares in the application. The bidders offer their selling prices, and the company repurchases the securities at prices lower to higher until the required number of shares is purchased.

It is important to note that the shares bought back from the market acquire the status of treasury shares. This implies that they do not give additional voting rights, the company does not pay dividends on them, and they do not participate in the division of the company's assets. Also, companies that buy their shares must sell them no later than one year after the purchase at a price that will not be lower than the market price or redeem them at the expense of the company's share capital. It is possible for issuers to circumvent this obstacle by holding a share buyback through a subsidiary. All of the above conditions of purchase and sale will not apply to this method. When the shares are purchased on the balance sheet of the subsidiary, the securities acquire quasi-treasury status.

Compulsory Stock Buyback

The legislation provides for certain forms of protection of minority shareholders' interests. When decisions are made that worsen investment conditions, the management of the JSC is obliged to publish an offer to buy back shares from shareholders who voted against these decisions or did not vote at all.

Issues with such decisions may include:

• takeover and merger;
• a spin-off of a subsidiary at the expense of the share capital;
• changes in the charter documents that reduce the rights of shareholders;
• an additional issue of securities;
• conclusion of a major transaction or a related-party transaction.

And this is not the whole list.

Negative Consequences of a Compulsory Buyback

Justifications for compulsory buyback, appealing to public opinion, are built on the assertion that the freedom of sole management increases the success of the business and the efficiency of business operations.

We would agree, perhaps, if the business is built on taking over, devastating and subsequently bankrupting companies that are steadily generating returns.

In other cases it is just a form of hypocritical demagogy:

• Firstly, because minority shareholders have never been a hindrance to the owners of firms when it is necessary to sneak the desired decision - in their absence at the meeting there are forms of absentee voting, and if a shareholder stubbornly ignores his rights and obligations, no one prevents him from filling out a voting form on his behalf;
• Secondly, because nobody in the process of consolidation of the whole package has the possibility to plan clearly the improvement of management and increase of business efficiency - God willing, in the next year at least, to deal with these issues;
• Thirdly, because individual management by no means guarantees an increase of the same efficiency - it is not difficult to find a lot of examples of companies under individual management going bankrupt and ceasing to exist.

In fact, the main goal of a strategic investor is to capture control over financial flows and redirect them in his own interests. This is not very good:

• for the firm's employees – when there is a change of ownership, there is often a tendency to lower wages;
• for the state – the temptation to avoid taxes has not yet disappeared, and with a sole proprietorship, it is easier to "solve" this problem.

The social aspect is also important in the practice of compulsory buyout. The former minority shareholders are deprived of passive income, which, if successfully invested, can exceed the income from bank deposits.

Forcing minority shareholders out of the investment process leads to the concentration of material wealth in the hands of a small number of the wealthiest members of society. The level of social stratification grows, and the low priorities of social policy threaten to disturb the stability of the social order.

If by the procedure of compulsory repurchase the law stipulates equivalent compensation of material losses of minority shareholders - it is another question whether it is equivalent in reality - then there is no question of moral costs. A person spends time and effort to create passive income, he is deprived of the results of his lawful labor "in the interests not only of the owner of the company but of the whole state," and not a single structure of state power considers it necessary to compensate for moral damage.

This undermines faith in the principles of social justice, and reliability of life benchmarks, and demonstrates the indifference of the legislative authorities to the conditions of existence of the rank-and-file population.

How Buybacks Affect a Company's Financial Performance

First and foremost, a company's shareholder equity is reduced: the finances go out of the accounts when it is purchased, but the shares, whether repurchased or becoming treasury shares, are not included in the assets. At the same time, the company's return on equity and earnings per share increase if performance is maintained.

Benefits for the Investor

The repurchase of shares is generally beneficial:

• for the passive investor who is content with dividends because the amount of the dividend increases with earnings per share;
• an active stock market speculator, as the share price begins to increase under the influence of an objective factor, i.e. an increased buyback, as well as subjective factors, such as rumors, official information, and frenzy.

Potential Pitfalls and Manipulations

The announcement of the buyback procedure is in itself an incentive for some categories of traders to intensify buybacks in the stock market, especially for those who prefer to work short-term on the news. Such traders may be in for an unpleasant surprise if the announced buyback does not take place.

During the buyback process, some of the company's fundamentals change, such as:

• EPS – earnings-per-share ratio;
• ROE – lucrativeness ratio, which is a signal to more serious traders.

Mass buybacks begin: the greater the volume of redemptions, the higher the price rises.

At certain stage gains-securing begins, which also takes on a mass character at the end of the buyback. And here - the latecomer loses: the trader, having bought at a high price level, is left with shares at a low price.

He has little choice of what to do next:

• He can either fix his losses, which he will definitely do if the assets were bought with the use of leverage;
• or switch to a long-term investor and wait for the moment when the stock price rises to a beneficial or acceptable level.

If the procedure was honestly intended to increase their own shares, the trader has the opportunity to wait for the desired in a short time. If it was a tricky manipulation from the beginning - the issuer, or rather a professional hired by him, played up his shares with insider information about the volume and timing of the buyback, and then at the right moment he sold some or all of the purchased volume, the trapped trader has little chance of getting out of the situation without a loss.

How to Analyze the Market During a Stock Buyback

To reduce non-trading risks, which are various kinds of price manipulations, you should not lose vigilance, and before taking working decisions analyze the market situation, study available statements of the company which conducts buyback for the last two or three years:

• If it's clear that the company is saddled with debt and revenue and return margins are low, you shouldn't get involved in buying these stocks.
• If the statements and information about the assets, founders, structure, and composition of the company are not available, one should at least be guided by generally accepted patterns and the fundamental indicators already mentioned.
• It is advantageous to buy a company's stock when its price is near the cycle lows and when its P/E-price-to-earnings ratio is close to the average of other companies in the same sector. Otherwise - the price is at the highs, P/E is above the industry averages – there is a high probability of manipulation being prepared.

Big Companies and Their Buybacks

In May 2018, Apple announced a $100 billion buyback program, with the company also promising to increase its quarterly dividend by 16%. This announcement was not surprising, even though the cost of the program was comparable to Ecuador's GDP. The company benefited from the buyback of its shares because it reduced tax payments. Apple had by then accumulated a large amount of cash, which the company was holding abroad because of high tax rates. Carrying out the buyback, therefore, saved on tax payments as well as increased the value of the stock.

Conclusion

We may conclude that almost always the process has positive consequences for investors. At the same time, it is necessary to soberly assess the situation and realize that the buyback may also bring losses to the holders. It is therefore important to evaluate the entire issuer, analyze its financial statements, monitor the news background, etc. The most advantageous option for the holders is to settle the securities after the buyback. It is important to analyze the issuing company in terms of its past actions, and openness, to make the right conclusions.

It is not a good idea to select the stocks of a particular corporation based solely on the fact that it conducts buybacks. Be sure to use all possible tools for predicting quotes. A chart of the rise and fall of the price on the stock exchange is not exhaustive.

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