What Share Buy Backs do

The ABC of Share Buyback

Share buybacks are back in fashion. In 2004, globally, companies announced plans to repurchase $230 billion in stock, more than double the volume of the previous year. During the first three months of 2005, buyback announcements exceeded $50 billion. And with large global corporations holding $1.6 trillion in cash, there are signs that buybacks will gain momentum in the coming months. In India too, we can expect this trend to pick up, as corporate performance has been quite strong.

In general, a buyback can have a positive impact on the share price both due to change in the capital structure and the signals it sends. A buy back increases the debt component in the capital and reduces the amount of cash available with the company. The cost of capital is lower when a company uses some debt for financing, because interest payments in case of debt are tax deductible while dividends in case of equity are not. On the other hand, holding excess cash raises the cost of capital, as the interest earned on cash is taxable.

The impact on share prices due to the tax effect can be quantified. But academic research indicates that buyback announcements typically result in a much bigger rise in share price than this analysis would suggest. In the global context, research indicates that companies initiating small repurchase programs see an average increase in their share price of 2 to 3 percent on the day of the announcement. Those that undertake larger buybacks, involving around 15 percent or more of the shares, see prices increase by some 16 percent, on average. Clearly, there must be a better explanation for this larger positive reaction to share buybacks.

Logically, companies must repurchase shares when they have accumulated more cash than they can invest profitably. Buyback is not good news in itself, but shareholders are frequently relieved to see companies giving back the excess cash rather than wasting it on unprofitable investments. This signal can be further strengthened if the company’s managers declare that they will not sell any of their own stock to the company. Indeed, it is often the case that during stock repurchase programs, senior managers and directors announce they will hold onto their stock. So it is not surpris­ing that announcements of offers to buy back shares above the market price have prompted a larger rise in the stock price, averaging about 11 percent in the US.

In many cases, a company seems to be undervalued just before it announces a buyback, reflecting an uncertainty among investors about what the management will do with the excess cash. The strength of the market's reaction also seems to indicate that shareholders often realize that a company has more cash than it can invest, long before the buyback announcement is made.

For cash-rich industries with insufficient investment opportunities, it makes sense for the management to pay out the excess cash sooner rather than later. But in industries with good investment opportunities, it is clearly wrong to buy back shares in order to achieve Earnings Per Share (EPS) targets. So care should be taken, especially because management compensation in many companies, is linked to EPS, that managers do not do buybacks at the risk of affecting the long-term health of the company.

Many market participants and executives believe that a repurchase by reducing the number of outstanding shares, also raises a company's share price. The argument is that the same earnings divided by fewer shares will lead to a higher EPS and consequently a higher share price. But this is not quite correct. The EPS goes up but the share price may not.

Say a company X has 100 shares outstanding. It earns Rs.1,000 a year, all of which is paid out as a dividend. The dividend per share is, therefore, Rs.1,000/100 = Rs.10. Sup­pose that investors expect the dividend to be maintained indefinitely and that they require a return of 10 percent. In this case, basic time value theory in financial management will tell us that the present value of each share = Rs.10/.10 = Rs.100. Since there are 100 shares outstanding, the total market value of the equity = 100 X Rs.100 = Rs.10,000.

Now suppose the company announces that instead of paying a cash dividend in year 1, it will spend the same money repurchasing its shares in the open mar­ket. The present value of the Rs.1,000 re­ceived from the stock repurchase in year 1 is (Rs.1,000/1.1) = Rs.909. The present value of the Rs. l,000-a-year dividend starting in year 2 is [(Rs.1,000/(.10 X 1.1)] = Rs. 9,091. Each share continues to be worth (909 + 9091)/100 = Rs.100 just as before.

We can redo the calculations in a different way. Those shareholders who sell their stock back to the company will not receive any dividend. So the price at which the firm buys back shares must be 10 percent higher than today's price, or Rs.110. If the company spends Rs.1,000 it can buy Rs.1,000/Rs.110 = 9.09 shares. The company starts with 100 shares and buys back 9.09. Therefore 90.91 shares remain outstanding. Each of these shares will be entitled to a future dividend stream of Rs.1,000/90.91 = Rs.11 per share. The value of each of these shares today is therefore 11/(.1 X 1.1) = Rs.100.

This example illustrates that other things being equal, company value is unaffected by the decision to repurchase stock instead of paying a cash divi­dend. In practice, because of the different signals they send, the impact of dividends and share buyback may be different. Dividends tend to be regular payouts whereas buybacks are usually one time events.