Share Buybacks: A Double-Edged Sword for Investors?

Share buybacks refer to the practice where a company purchases its own shares from the open market or directly from its shareholders. 

In practice this results in a reduction in the number of outstanding shares available in the market, and so buybacks can also have an impact on the stock’s price, as the reduction in supply can drive up demand and, consequently, the price. 

This indirectly returns value to existing shareholders. This is sometimes used as an alternative to dividends, which is a more direct way of delivering value (we will discuss one approach versus the other later).

Costs associated with purchasing the shares in a buyback can come from two main sources. Companies can either use their available cash reserves from profits, or even borrow funds to execute share buybacks.

Ultimately, the decision to engage in share buybacks depends on a company’s financial goals, market conditions, and its outlook on growth and shareholder value. Here’s an example of how a share buyback could work:

Company: XYZ Corporation

• Current Number of Outstanding Shares: 10 million
• Current Stock Price: $50 per share
• Market Capitalization: $500 million (10 million shares x $50 per share)

Implementation of Share Buyback:

• XYZ Corporation announces a share buyback program of up to 2 million shares.
• A budget of $100 million is approved for the buyback program.
• The buyback will be executed over a specified period, for example, over the next 12 months.
• XYZ Corporation will buy back shares from the open market at prevailing market prices.
• Total Cost of Repurchased Shares: 2 million shares x $45 per share = $90 million

The Market’s View of Share Buybacks

The market’s view on share buybacks can vary considerably and depends on several factors. The major issues include the following potential opinions.

1. Positive Signal of Undervaluation: 
   When a company announces a share buyback, it can signal to the market that the company believes its stock is undervalued. This can lead investors to view the stock more favourably and potentially drive up demand, causing the stock price to rise.
2. Improvement in Earnings metrics
   By reducing the number of outstanding shares available, this can lead to an increase in earnings per share (EPS), even if the company’s actual earnings remain the same. This can make the company’s financial performance appear stronger and more attractive to investors. Consequently, other earnings metrics will also change, e.g., P/E ratios.
3. Return of Capital to Shareholders: 
   Share buybacks are often seen as a way for companies to return excess capital to shareholders. Investors looking for income through capital appreciation might view buybacks positively, as they can lead to an increase in the stock price.
4. Concerns Regarding the Use of Funds versus other Potential Projects: 
   Critics of share buybacks argue that companies sometimes prioritize buybacks over investments in research, development, and long-term growth. This can be a concern if buybacks are used to artificially inflate EPS without contributing to the company’s fundamental growth.
5. Dividend vs. Buyback Debate: 
   Some investors prefer dividends as a means of returning value, as they provide direct cash payouts. Others appreciate buybacks, as they can lead to increased stock prices, but they don’t provide the same level of immediate income as dividends.
6. Effect on Debt Levels: 
   If a company uses debt to fund its buybacks, it can increase its leverage and financial risk. Investors might be cautious if a company’s debt levels rise significantly due to buybacks. Additionally, if a company already has significant debt levels some market participants may feel that the capital used for the buyback would have been better used to reduce these, particularly if there are economic pressures currently in financial markets.

Summary

Share buybacks can have both positive and negative implications for a company and its stakeholders, and market opinions can significantly differ depending on many factors, some of which have been discussed above. Buybacks may enhance shareholder value by signalling confidence in the company’s future prospects and increasing key financial ratios. However, they can also be criticized if they are used to artificially boost stock prices without addressing underlying operational issues and potential opportunities for growth that similar company investments could provide.