This article targets the underlying reasons for a company to adopt share repurchase as a strategy and explores the pros and cons of this corporate strategy.
All public companies raise capital by issuing shares. These shares are publicly listed and traded in the stock market with the intent of purchase by individuals or corporate investors. But at times the need arises for a company to buy back its shares. This is known as a share repurchase or share buyback. As counter-intuitive as this may sound, over the last decade this has emerged as a popular complementary payback option for shareholders along with dividend payouts.
Right from the startup phase, a company starts issuing stocks mostly to create attractive remuneration packages to hire top talent and attract the best-suited investor in the market. Issuing shares dilutes founder shares but raises capital big enough to meet the startup’s growth and expansion plans. As the company starts making profits, share prices accelerate as well. Why then should a company consider share buybacks at any stage of the business? What might motivate a company to invest cash and repurchase its shares at a higher price? Let’s take a look.
What is a share repurchase or share buyback?
A share repurchase is a management decision of a publicly traded company to buyback already issued shares. The issuing company repurchases these shares by paying shareholders the market price per share. An immediate effect of this action is a drastic reduction in the total number of outstanding shares. This effect in turn triggers an accelerated demand of shares in the market subsequently increasing share prices or earnings-per-share (EPS). These re-absorbed shares are canceled off the market and held by the company as treasury shares i.e. these are not publicly held anymore or show as outstanding.
A company can afford a share buyback only when its cash coffers are strong. However, post the buyback, the issuing company’s financial statements will show a considerable change as there will be a decline in the company’s cash reserves. Besides, there will be a massive reduction in shareholder equity as well. All of these in turn affect the company valuation as these factors are integral to the metrics used by investors to assess a company’s financial health. Why then should a company consider a share buyback at all?
Reasons for share repurchase
Despite seemingly being a step back in equity dealings, share repurchase has evolved as a positive financial strategy because:
- Consolidates ownership: Issuing shares makes sense when a business is expanding and needs more capital. But what happens when the company is performing well but does not have growth potential for a while or the need to raise more? In this case, too many outstanding shares become a liability owing to the obligation of dividend payouts. Besides, share ownership also means voting rights. Hence, share buybacks, in this case, is beneficial as it consolidates the issuing company’s ownership.
- Increases value of equity: A company is liable to pay a set amount as dividends to shareholders. After a share repurchase, since the number of outstanding shares reduces, each existing shareholder will receive a higher annual dividend for their holdings. Thus as the company continues to grow and profit, owing to an increased EPS, there is an increase in dividend growth.
- Indicates good financial health: A company must be in stable financial health to attempt share buybacks. This move helps close the gap between excess capital and dividends. The company thus can return more to the shareholders. Besides the market perceives the company to be financially stable thus attracting lucrative investors.
Advantages and disadvantages of share repurchase
Share repurchases can be seen as a company’s way of restructuring the business. On one hand, while share buybacks benefit include consolidating ownership and increasing the value of equity, on the other hand the market might perceive this move as a distress signal. Hence share buybacks can have positive as well as negative effects. Here are some basic advantages and disadvantages of this strategy:
Advantages of share repurchase
- When shares become undervalued or are at a declining phase, a company can use this move to provide more returns to shareholders
- It is a good way to increase earnings-per-share (EPS). Also, it is a signal to the market that share prices are about to increase
- Indicates good financial health of the company
- Attracts investors as they are assured of less economic instability
Disadvantages of share repurchase
- Investors might perceive limiting outstanding shares as a restriction in company expansion
- There will be a decline in company cash reserves post a repurchase. This affects company valuation calculations
- If a company borrows money to buy back shares, credit ratings will go down. Besides if for unforeseen reasons the market crashes, the company will end up in huge trouble
What are some impacts of a share repurchase?
As we have discussed so far, some of the obvious impacts of share repurchase include a reduction in the total number of outstanding shares in the market, inflated EPS or Cash Flow Per Share (CFPS), increase in the value of equity, and consolidation of ownership. Apart from these, the most significant impact share buybacks create in the market is the Signaling effect.
The Signaling effect is a company’s way of indicating the market that the company management is expecting inflation in share prices shortly. This can happen due to various reasons such as acquiring another strategically important company, dissolving an underperforming business unit, the introduction of a new product line, etc. Either way, a share repurchase signals the market that the business is facing situations that are placing upward pressure on the stock price.
How share repurchases affect company valuation?
A company valuation is an integral process of establishing the current worth of a business. It is required in situations such as evaluating a part or whole of a business for sale, a possible partnership, acquisition, taxation, evaluating the founder’s net worth, etc. To determine the exact valuation professional, evaluators are involved who use various metrics to analyze the company’s capital structure, sources of future earnings, and the market value of all company assets. Irrespective of the method used, the financial statements of a company form the basis of all evaluation metrics.
Share repurchase has a direct impact on the company’s balance sheet. There will be a considerable dip in the cash reserves as well as outstanding equity. But the return on assets and equity will increase. Cash flow is the basis of most company valuation metrics, share buybacks have a direct impact on the valuation of a business. Here are some of the popularly used business valuations methods that will be impacted by a share repurchase:
- Market Capitalization: This method multiplies the price of each share by the total number of outstanding shares
- Times revenue method: A multiplier is applied to a stream of revenue generated over a certain period. The multiplier depends on the industry and the business environment
- Discounted Cash Flow method (DCF): This method first considers the current value of a company and projects future cash flows considering inflation.
- Book value: This method is simply based on a company’s balance sheet. It subtracts the total liabilities of a company from its total assets. This determines the total equity value of company shareholders.
- Liquidation value: This is the total cash a company will receive after all assets are liquidated and liabilities are paid off.
Share Buybacks vs Dividends
Paying dividends is an obligation a company has towards its shareholders, while share buybacks do not incur any such promises. Though both these methods increase shareholder returns, their method of operation varies. Here is a snapshot of share repurchases vs dividends.
The question of dividends does not arise in the case of startups as their shares are not available for public trading until an IPO. Once a company’s shares start trading publicly, the process of dividends paybacks arises. The company sets aside a part of its annual profits (after tax deductions) in an account known as the retained earnings. This account is dedicated to capital expenditures and dividend payouts.
Dividends follow a set structure of returns. They are paid periodically following a timeframe and taxed as it is. It is a share of profits that a company shares with its shareholders on a fixed schedule. They are mostly paid in cash. But sometimes, companies may opt to pay equity instead of the dividend’s worth in cash. From an investor’s point of view, dividends are their basic return on investment. Reliability on dividend payouts can be expected only from established companies that have a stable cash flow and predictable revenues.
Meanwhile, Share buybacks are a one-time event further along the company operations. A company is not obligated to promise shareholders of buybacks at any stage of the business. It is at the absolute discretion of the company management to declare a buyback or not. Sometimes, share prices could be sliding beyond control and the company decides to buyback. At other times, company expansion might be halted arising from the need to cut down on the total number of outstanding shares, and the company might need to buyback. Thus, unlike dividends, share buybacks can happen anytime and the taxes are deferred until the shares are sold.
Considering a share repurchase for your company?
Equity management is an integral part of every company. It is best to set up a process to issue, track, and manage shares right at the startup stage. This can be easily done by creating a cap table on an excel sheet. However, for companies further along with the business where multiple stakeholders are involved, investing in equity management software is advisable. Eqvista is one of the market leaders in this segment.
We provide end-to-end digital services for a company’s extensive equity distribution needs. Our software also allows for customized access to equity accounts for all shareholders. Equity management has never been simpler.