Share Buybacks Meaning vs Dividends & Valuations & effect on stock price
In recent years we have seen a number of companies, especially companies from the technology sector, announcing buyback of shares. Before we get into the nuances of buybacks in India let us understand how the global scenario on buybacks operates. Globally, there are two ways that a company can buy back its own shares.
So, why does a company buy back shares? What are the reasons for buyback of shares? One needs to understand the benefits for the shareholders and for the company in question. The key question is about the share buyback benefits for shareholders.
Stock buybacks refer to the repurchasing of shares of stock by the company that issued them. A buyback occurs when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously distributed among public and private investors.
With stock buybacks, aka share buybacks, the company can purchase the stock on the open market or from its shareholders directly. In recent decades, share buybacks have overtaken dividends as a preferred way to return cash to shareholders. Though smaller companies may choose to exercise buybacks, blue-chip companies are much more likely to do so because of the cost involved.
Since companies raise equity capital through the sale of common and preferred shares, it may seem counter-intuitive that a business might choose to give that money back. However, there are numerous reasons why it may be beneficial to a company to repurchase its shares, including ownership consolidation, undervaluation, and boosting its key financial ratios.
Unused Cash Is Costly
Each share of common stock represents a small stake in the ownership of the issuing company, including the right to vote on the company policy and financial decisions. If a business has a managing owner and one million shareholders, it actually has 1,000,001 owners. Companies issue shares to raise equity capital to fund expansion, but if there are no potential growth opportunities in sight, holding on to all that unused equity funding means sharing ownership for no good reason.
Businesses that have expanded to dominate their industries, for example, may find that there is little more growth to be had. With so little headroom left to grow into, carrying large amounts of equity capital on the balance sheet becomes more of a burden than a blessing.
Shareholders demand returns on their investments in the form of dividends which is a cost of equity—so the business is essentially paying for the privilege of accessing funds it isn't using. Buying back some or all of the outstanding shares can be a simple way to pay off investors and reduce the overall cost of capital.
Preserves the Stock Price
Shareholders usually want a steady stream of increasing dividends from the company. And one of the goals of company executives is to maximize shareholder wealth. However, company executives must balance appeasing shareholders with staying nimble if the economy dips into a recession.
One of the hardest-hit banks during the Great Recession was Bank of America Corporation. The bank has recovered nicely since then, but still has some work to do in getting back to its former glory. However, as of the end of 2017, Bank of America had bought back nearly 300 million shares over the prior 12-month period.2 Although the dividend has increased over the same period, the bank's executive management has consistently allocated more cash to share repurchases rather than dividends.
Why are buybacks favored over dividends? If the economy slows or falls into recession, the bank might be forced to cut its dividend to preserve cash. The result would undoubtedly lead to a sell-off in the stock. However, if the bank decided to buy back fewer shares, achieving the same preservation of capital as a dividend cut, the stock price would likely take less of a hit. Committing to dividend payouts with steady increases will certainly drive a company's stock higher, but the dividend strategy can be a double-edged sword for a company. In the event of a recession, share buybacks can be decreased more easily than dividends, with a far less negative impact on the stock price.
The Stock Is Undervalued
Another major motive for businesses to do buybacks: They genuinely feel their shares are undervalued. Undervaluation occurs for a number of reasons, often due to investors' inability to see past a business' short-term performance, sensationalist news items or a general bearish sentiment. A wave of stock buybacks swept the United States in 2010 and 2011 when the economy was undergoing a nascent recovery from the Great Recession.3 Many companies began making optimistic forecasts for the coming years, but company stock prices still reflected the economic doldrums that plagued them in years prior. These companies invested in themselves by repurchasing shares, hoping to capitalize when share prices finally began to reflect new, improved economic realities.
If a stock is dramatically undervalued, the issuing company can repurchase some of its shares at this reduced price and then re-issue them once the market has corrected, thereby increasing its equity capital without issuing any additional shares. Though it can be a risky move in the event that prices stay low, this maneuver can enable businesses who still have long-term need of capital financing to increase their equity without further diluting company ownership.
Buybacks are a more tax-effective means of rewarding shareholders
This advantage became pronounced in India after the Union Budget 2016 when the government announced the 10% tax in the hands of shareholders if the annual dividend exceeded Rs.1 million. Now, dividends paid by companies are being virtually taxed at 3 levels. Firstly, dividends are a post tax appropriation, and then there is dividend distribution tax (DDT) of 15% when the company pays out the dividend and finally there is the 10% tax on shareholders. The 10% tax actually hit promoters and large shareholders the most. In comparison, buybacks are attractive in tax terms even after considering the 10% tax on LTCG that was imposed in the 2018 budget.
It's a Quick Fix for the Financial Statement
Buying back stock can also be an easy way to make a business look more attractive to investors. By reducing the number of outstanding shares, a company's earnings per share ratio is automatically increased – because its annual earnings are now divided by a lower number of outstanding shares.
Also, short-term investors often look to make quick money by investing in a company leading up to a scheduled buyback. The rapid influx of investors artificially inflates the stock's valuation and boosts the company's price to earnings ratio. The return on equity ratio is another important financial metric that receives an automatic boost.
One interpretation of a buyback is that the company is financially healthy and no longer needs excess equity funding. It can also be viewed by the market that management has enough confidence in the company to reinvest in itself. Share buybacks are generally seen as less risky than investing in research and development for new technology or acquiring a competitor; it's a profitable action, as long as the company continues to grow. Investors typically see share buybacks as a positive sign for appreciation in the future. As a result, share buybacks can lead to a rush of investors buying the stock.
Returns cash to the shareholders of the company
In India, shareholder activism by large shareholders and institutions is still not too prominent, but it is gradually building up. For example, in the US companies like Apple were forced by influential shareholders to distribute more cash to shareholders through buybacks. In the past we have seen many companies diversifying into unrelated areas just because they were flush with funds. A better idea may be to return the cash to shareholders instead and let them decide what they want to do with the excess money. That kind of shareholder activism is only just about beginning to be seen in India.
It can help the promoters to consolidate their stake in the company
There are times when the promoters may be worried about their holding in a company going below a certain level. A buyback is an offer and it is up to the shareholders whether to accept or not. If promoters accept the buyback then it maintains their stake and gives cash. Alternatively, if their forfeit the buyback, they are able to increase their stake in the company. This is critical when the company is wary of other companies trying to take them over.
Downside of Buybacks
A stock buyback affects a company's credit rating if it has to borrow money to repurchase the shares. Many companies finance stock buybacks because the loan interest is tax-deductible. However, debt obligations drain cash reserves, which are frequently needed when economic winds shift against a company. For this reason, credit reporting agencies view such-financed stock buybacks in a negative light: They do not see boosting EPS or capitalizing on undervalued shares as a good justification for taking on debt. A downgrade in credit rating often follows such a manoeuvre.
Effect on the Economy
Despite the above, buybacks can be good for a company's economics. How about the economy as a whole? Stock buybacks can have a mildly positive effect on the economy overall. They tend to have a much more direct and positive effect on the financial economy, as they lead to rising stock prices. But in many ways, the financial economy feeds into the real economy and vice versa. Research has shown that increases in the stock market have an ameliorative effect on consumer confidence, consumption and major purchases, a phenomenon dubbed "the wealth effect."4
Another way improvements in the financial economy impact the real economy is through lower borrowing costs for corporations. In turn, these corporations are more likely to expand operations or spend on research and development. These activities lead to increased hiring and income. For individuals, improvements in the household balance sheet enhance chances they leverage up to borrow to buy a house or start a business.
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