What is a Share Buyback and Why Do Companies Do it?

In this article, we’re going to look at what a share buyback is, how they work, why companies do them, and whether investors benefit.

When companies have built up surplus cash, they have three options. 

1. They can invest it. 
2. They can keep it for a rainy day. 
3. They can hand it over to shareholders either as cash in the form of a dividend or buy the shares back.

In 2021, UK companies announced more than £2bn of share buybacks, following the market freeze during the height of the Covid-19 pandemic.

What exactly is a share buyback?

Also known as stock repurchase, it’s essentially when a company uses its accumulated cash to buy back its shares from the marketplace. As a result, the shares become more valuable as there are fewer shares available in the market. 

In the UK, a limited company can buy back shares in itself but only after certain conditions are met. These are outlined in Companies Act 2006 (CA 2006). Under the act, a company can buy back its shares through an off-market or on-market purchase.

A company needs to shareholder approval from the shareholders in order to buy back its shares. It usually does that at the Annual General Meeting. The shareholders can also vote to agree on a buyback policy. In the UK, the ceiling of share capital that can be brought back is 15%. However, that can be breached in exceptional circumstances subject to investor agreement.

Research by BIS shows that apart from the US, Japan, the UK, France, Canada and China are the five countries with the largest 2019 buyback amounts. The recorded repurchases were jointly worth $130 billion in that year.

And in 2021 according to Proactive Investors, companies such as Diageo PLC , Unilever PLC, and BP PLC all announced massive share buybacks.

A share buyback is a popular route for shareholder exits. However, they are not without controversy. In fact, they have recently been touted as the next big FTSE controversy. This is because some management teams buy back shares with company capital to decrease the shares in issue, then issue lucrative options packages to themselves which dilutes the shares in issue. But that’s another topic!  

How does a share buyback work?

There are three main ways a company can do this:

1. By purchasing its own shares on the open market

This is the most common stock buyback approach. The company simply buys its own shares at the current market price.

2. By issuing a tender offer to its shareholders

This is when the company effectively offers to buy back some or all of its shares directly from them. Generally, it indicates the total number of shares the company is looking to repurchase, the price range it will pay per share (or fixed purchase price), plus the expiry date of the offer. A stock repurchase of this type usually involves paying shareholders a share price that is significantly higher than the current market value.

3. By negotiating a private buyback

The least common approach involves negotiating the purchase of shares privately and directly from a large, individual shareholder.

Example of a share buyback

Diageo PLC announced on Monday 21 February 2022 that it has started a share buyback for up to 1.7 billion pounds ($2.31 billion) as part of its return of capital programme.

It entered into a deal with UBS to undertake the buyback programme. Repurchases of GBP1.4 billion are expected to be completed by June 30.

This is the third phase of its return of capital program of up to £4.5 billion. Diageo repurchased shares with a value of £2.25 billion under the first two phases. These were completed in early 2020 and 2022, respectively.

Why do companies buy back shares?

There are six main reasons for share buyback, as follows:

1. Boost undervalued shares

This is done to increase the price of its shares when a company believes they have become undervalued in the marketplace.

2. Provide cash distribution

Share buybacks are often used to provide current shareholders with a cash distribution, and this is viewed as a bonus by many investors.

3. Increase Earnings Per Share (EPS)

One of the main ways a stock repurchase can improve investment value is through an increase in Earnings per Share (EPS).

4. Reduce cash outflow

Companies can use share buybacks to reduce their cash flow. Fewer outstanding shares means there are fewer dividend payments to pay. Instead of a dividend cut, a buyback reduces dividend obligations as there are fewer remaining shares.

5. Make changes in capital structure

A company’s capital structure changes when it initiates a share buyback. This is because fewer outstanding shares equates to less outstanding equity.

This change in structure increases a company’s Return on Equity (ROE), simply because its generated returns are now linked to a lower level of equity.

This is viewed as a positive feature in the marketplace.

6. Repurchase shares from large shareholders

If a large shareholder wants to liquefy their holdings the company may offer to repurchase their shares. 

What happens to share prices after buyback?

The number of shares in the public domain is reduced following a buyback. Consequently, the percentage of that company each remaining shareholder owns increases.

In the short term, the share price may rise. This is because shareholders know that a buyback will immediately boost earnings per share. However, in the long term, a buyback may or may not be beneficial to shareholders, which we will look at now.

Is a share buyback considered good?

Critics argue that companies should plough profits back into the business to generate growth rather than buy back shares. As with most investments, there are pros and cons with share buybacks and we will examine the strengths and pitfalls in turn.

Advantages of share buybacks

The main advantage of a share buyback is that it enhances the confidence of shareholders in the company’s owners. This is because the fact that the owners are buying their own stock is an indication that they expect the price of the shares to rise in the future.

Another benefit is that it helps the company use up excess cash which was lying idle Obviously this excess cash earns no income. Furthermore, if the company doesn’t have enough opportunities for expansion, then it can use that excess cash for buying back the shares. For example, a company may find it only has projects available where the cost of capital is higher than buying back shares in itself. 

Furthermore, buyback programs on the stock exchange reduce the chances of a takeover of the company by other companies. This is because due to the buyback of shares, promoter stake increases. As a consequence, the higher the promoter stake, the less likely are the chances of a takeover by other companies.

The directors of the company may also decide to do buybacks for its employees’ share scheme instead of creating new shares.  

Disadvantages of share buybacks 

The biggest disadvantage of a share buyback program is that the cash used by the company to buy back the shares has an opportunity cost. This is because excess cash could be used by the company for a variety of productive activities which may, in turn, result in an increase in profits of the company. This means that if the company is going for share buyback it is clearly overlooking all the other alternatives in which that cash can be used.

Another drawback of a share buyback is that sometimes it may be used to give a false signal about the company. The reason for this is to increase the price of shares so that they can sell them. Therefore, investors should be wary of those companies whose history is questionable. This is because when the news of a share buyback is announced, the price of the shares rises which can be misleading for innocent investors.

The final key disadvantage of the share buyback process is that many people view it as a sign that the company has no profitable opportunity in the current business and that is the reason why they are using their excess cash for a share buyback which in turn creates a negative perception about the company in the minds of long-term investors who are obviously looking for capital appreciation due to growth in the company.

Conclusions

To conclude, a share buyback is primarily intended to increase shareholder value. However, they are certainly controversial. Investors should always check when a share buyback is announced that they are of any pitfalls such as overvalued stock or an increased debt load. It’s important to study the company’s financial reports to ascertain the real motive behind their decision to reduce the number of outstanding shares.

That said, buybacks have historically been a great way for the remaining shareholders to realise value. This is why shareholder resolutions are often in favour of buybacks to reduce the share issue.