Investing Basics: What is a share buyback and why is it done?

When companies have built up cash they can invest it, keep it in reserve or hand it to shareholders by either paying a dividend or buying shares back; UK companies bought back more than £2bn of shares as the economy recovered from the pandemic, and now many energy companies are using their vast windfall profits in the same way – writes Christian Leeming.

What exactly is a share buyback?

 
Sometimes ‘stock repurchase’ is when a company uses its accumulated cash to buy its shares, making them more valuable.

In the UK, with shareholder approval, a limited company is allowed to buy back shares up to 15% of its share capital through an off-market or on-market purchase.

In 2019 recorded global repurchases were jointly worth $130bn, with Diageo, Unilever and BP announcing huge buybacks; they are not without controversy and have been touted as the next big FTSE controversy.
 

How does a share buyback work?

 
There are three ways a company can do this; it can simply buy in the market, it can issue a tender to buy a number of shares from shareholders, typically at a higher than market price, or it can negotiate directly with large individual shareholders.
 

Why do companies buy back shares?

 
There are six main reasons: to increase the price of shares it believes are undervalued, provide investors with a bonus, improve investment value by increasing earnings per share (EPS), reduce cash flow by reducing the number of shares paying dividends, change a company’s capital structure by increasing its return on equity (ROE), and help large shareholders liquefy their holding.

The number of shares in the public domain is reduced following a buyback so the percentage each remaining shareholder owns increases; the share price may rise in the short term.
 

Is a share buyback considered good?

 
Critics argue that companies should plough profits back into the business to generate growth; there are pros and cons.

Share buybacks enhance confidence of shareholders in the company’s owners, as it is an indication that they expect the share price to rise in the future; it helps the company use up excess cash potentially earning no income.

Buyback programs may reduce the chances of a takeover of the company by increasing the promoter stake; directors may also decide to do buybacks for its employees’ share scheme instead of creating new shares.

The biggest disadvantage is the opportunity cost where the excess cash could be used for a variety of activities which could increase profits of the company.

Another drawback is that it may give a false signal about the company, investors should be wary of companies with questionable history.

A key disadvantage is that it can be viewed as a sign the company has no profitable opportunity in the current business, which in turn creates a negative perception in the minds of long-term investors looking for capital appreciation due to growth in the company.

Share buyback is primarily intended to increase shareholder value but investors should always check for 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.

However, buybacks have historically been an effective way for remaining shareholders to realise value, which is why shareholder resolutions are often in favour of buybacks to reduce the share issue.