Share Repurchases

Friday, May 1, 2009

repurchases

Introduction

In some countries, such as the U.S., companies are allowed the option to buy back their own stock. This action is known as a share repurchase or buyback. A share repurchase allows existing shareholders to receive cash in exchange for a fraction of the corporation’s outstanding equity (i.e. shares). Ultimately, the number of shares outstanding decreases in exchange for cash. After a repurchase occurs, the firm possesses the option to suppress the shares or maintain them in reacquired stock (treasury stock); made available to re-issue as shares in equity. The United States has an open market, private negotiations (between firms and their shareholders), repurchase put rights (buying back the right to sell a share at a strike price), and self-tender repurchases. Self-tender repurchases are classified in two categories: Dutch auction and fixed price tender offers. 

There are alternative types of buy-backs. A selective buy-back occurs when offers are made to selected shareholders in the company. This type of buy-back must first be approved by all shareholders or a 75% majority (specialty resolution). Selling shareholders have the option to vote against a special resolution that would advocate a selective repurchase. Also, shares held for or by employees within a corporation may be repurchased by the firm. This employee share scheme buy-back beseeches an ordinary resolution. On-market buy-backs occur when a company repurchases its shares during trading on the stock exchange. However, this can only be executed once an ordinary resolution over the 10/12 limit is passed . Finally, a company listed on the stock exchange has the option of a minimum holding buy-back, wherein a firm buys unmarketable bundles of shares from shareholders. These purchased shares must be cancelled, but it does not demand a resolution.

There lays both advantages and disadvantages when a firm employs share repurchase options. Within these pros and cons lies diversified motivations and opportunities. Such will be discussed throughout the article.

Explaining Method of Stock Repurchasing

Ninety-five percent of all repurchases that occur in the U.S. are open-market stock repurchases. A corporation has the option of whether or not they announce their intent to repurchase shares in the open market. Conditions in the market decrees and sustains the option of how much, when, and whether or not to repurchase. These open-market buy-backs can last years. Conversely, daily repurchase limits restrain the amount of stock that can be bought over a given time period.

Fixed price tender offer buy-backs were once the only form of tender offer carried out using a fixed price. In 1981, Dutch auction share buy-backs were introduced as a surrogate form of tender offer. This form was first implemented by Todd Shipyards.

Fixed price tender offers determine, with public acknowledgement, an especial purchase price, the length of the offer, and the number of shares desired. It is possible for the offer to be made conditional upon the acquisition of a minimal amount of shares. In addition, it may allow removal of tendered shares before the expiration date of the offer. If shareholders decide to take part in the offer, they must also decide the amount of shares to delegate to the corporation at a certain price. 

Dutch auction offers delegate a range of prices wherein the shares will eventually be bought. Shareholders have the option to tender their stock at any price within the given range of prices. The lowest price which enables the company to purchase the amount of shares desired is classified as the purchase price. Investors who tendered equal to or less than that price are paid the purchase price by the company. It not enough shares are tendered, the offer is either aborted or all tendered shares are repurchased at the highest price within the price range.

Motivation behind repurchasing shares vary, as the exact reasons for the decision to buy back stock are usually never made known to a common investor. Over the past few decades, we have seen investors begin to question motives behind repurchasing as a way of generating shareholder value. The question is whether or not share repurchasing is one of the most beneficial ways a company can spend capital.

Benefits of Share Repurchasing

Share repurchasing aids in closing the hole between value and price. Big repurchase programs usually have an impact of helping the price coverage on the underlying value earlier. This is a vital tool used by active investors to aid in the realization of the value of their investments.

When a corporation announces that a share repurchase is occurring, management is indicating that the stock is undervalued and they believe in future cash flow growth. This could raise the share price in a significant way, as potential growth is a vital tool used in the valuation of a firm.

Repurchasing stock generates a comfy price backing surface for investors. This holds especially true in environments similar to our current market (recession & bear market conditions). An enormous stock buy-back program generates excessive stock price aid that can be used as a safety line for investors in the firm.

Repurchasing shares can be improved by using cash from the issuance of debt.  Extra cash held by a firm is not freely available for any use by the company. Shareholders claim ownership of the cash, and they expect good returns on equity investments.

By using debt issuances with interest rates below the cost of equity to repurchase shares, the firm’s leverage magnifies and the cost of capital decreases. Thus, return on capital invested by shareholders increases.  Also, savings on taxes transforms into an increased share price, as interest expenses paid on the debt can be tax deduced.

Repurchasing stocks translates into a decrease in outstanding shares. This creates an increase in earnings per share, all else equal. A high EPS indicates high profitability per shareholder. However, this ratio does not take in to consideration future cash flows and cost of capital, both of which create shareholder value.

Downfalls of Share Repurchasing

Vital to the success of firms are a cautiously selected system with rewards based on performance. So, management’s incentive to boost a firm’s stock price could lead to tampering of the numbers in an effort to increase stock value and receive bonuses.

Repurchasing shares could have a similar effect. Increased earnings per share, return on assets, and a reduced P/E ratio are all derived from the reduction in shares outstanding. Therefore, the firm’s management would have earned their bonuses at the shareholder’s cost. Warren Buffet has been noted on multiple occasions that he believes employee stock option programs and repurchase programs can be quite shady. Repurchasing their own shares allows investors to believe their shares are increasing in value (EPS stays undiluted); when in fact the share value is artificially inflated. So, insiders may quickly sell their stock and allow individual investors to purchase at higher levels because of the inflated price the shares now hold. However, long-term price have not been linked to share repurchases, but significantly affect short-term stocks.

Every now and then, firms could be lacking in exploration of alternative means of using excess cash. A decision must be made on whether or not the corporation can earn a higher return investing elsewhere. If a dollar earned by a company does not increase the firm’s value by as much, shareholders should have cash returned to them so they may explore other investments. 

However, it is important to keep in mind that every business situation is different. Firms may elect to retain a large portion of earnings because it is considered humiliating for a company to reduce dividends, even if they can’t profitably invest the excess cash. Investors react more adversely to a dividend cut than the withdrawal of a repurchase program. So, instead of increasing and reducing dividend payouts during periods of excess and low cash, respectively, corporations distribute conservative amounts of earnings in an effort to maintain an acceptable payout rate.

Conclusion

The common thought over the past few decades has been that it’s beneficial when a company desires to invest in itself. However, questions have been raised recently over the credibility and motives behind share buy-back programs. There’s no answer for whether or not a repurchase program will benefit or hurt a stock. Each situation is different.

As both an individual investor and a company, it is essential to understand what a repurchase program can mean for a firm company-wide. If a firm has announced a share repurchase plan, analyze the company’s financial standing. A cultured, financially healthy firm with strong dividends is likely to have increasing company and shareholder value in mind when repurchasing their own stock. Conversely, a company that announces a share buy-back while in poor financial standing with decreased earnings should be considered with more caution. In the event of a stock repurchase announcement, take a careful look at the firm involved preceding a final decision on what it may mean for the stock in the near future.

 

References

1 The 10/12 limit refers to ASIC's requirement that companies buy back no more than 10% of the voting rights in the company within 12 months

2 Bagwell, Laurie Simon and John Shoven, "Cash Distributions to Shareholders" 1989, Journal of Economic Perspectives, Vol. 3 No. 3, Summer, 129-140. 

3 Bagwell, Laurie Simon, "Dutch Auction Repurchases: An Analysis of Shareholder Heterogeneity" 1992, Journal of Finance, Vol. 47, No. 1, page 71-105. 

Bill Parish, Microsoft Financial Pyramid, Parish & Company, November 17, 1999. 

4 Jonathan Stempel, Buffett Calls Dexter Shoe His Worst Deal Ever, Thomson Reuters, February 29, 2008. 

Justin Pettit, “Is a Share Buyback Right for Your Company?” Harvard Business Review, April 2001. 

Richard Dobbs & Werner Rehm, The Value of Share Buybacks, The McKinsey Quarterly - McKinsey & Co., September 20, 2005. 

Rob Landley, Why Microsoft’s Stock Options Scare Me, The Motley Fool, February 17, 2000. 

"Share Repurchase." Investopedia. Forbes. 27 Jul 2009 <http://www.investopedia.com/terms/s/sharerepurchase.asp>.

"Share Repurchase Programs." About.com: Investing for Beginners. The New York Times Company. 27 Jul 2009 <http://beginnersinvest.about.com/cs/investinglessons/l/blsharerepurcha.htm>.

Todd Bishop, Microsoft to End Stock Options For Employees, Seattle Post-Intelligencer, July 8, 2003. 

Weinschenk, Matthew. "Share Buybacks: Why Companies Buy Back Shares and Which Ones Are Doing It Right." 12 Dec 2007. Investment U. 27 Jul 2009 <http://www.investmentu.com/IUEL/2007/December/share-buybacks.html>.

Friday, May 1, 2009
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