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Sunday, September 12, 2010

Understanding Shares Buybacks

Generally, companies buy back their shares when they perceive their own shares to be undervalued or when they have surplus cash for which there is no ready capital investment need. For example, Essar Oil, Reliance, Siemens and Infosys are some examples of companies that have bought back their shares. Share buybacks also prevent dilution of earnings. In other words, a buyback enhances the earnings per share, or conversely, it can prevent an EPS dilution that may be caused by exercises of stock option grants etc

Purpose of Share Buybacks

Companies making profits typically have two uses for those profits. Firstly, some part of profits are usually repaid to shareholders in the form of dividends. The remainder, termed stockholder’s equity, are kept inside the company and used for investing in the future of the company. If companies can reinvest most of their retained earnings profitably, then they may do so. However, sometimes companies may find that some or all of their retained earnings cannot be reinvested to produce acceptable returns.

Share repurchases are one possible use of leftover retained profits. When a company repurchases its own shares, it reduces the number of shares held by the public. The reduction of the float, or publicly traded shares, means that even if profits remain the same, the earnings per share increase. So, repurchasing shares, particularly when a company’s share price is perceived as undervalued or depressed, may result in a strong return on investment.

One reason why companies may prefer to keep a substantial portion of earnings rather than distribute them to shareholders, even if they aren’t able to reinvest them all profitably, is that it is considered very embarrassing for companies to be forced to cut dividends. Normally, investors have more adverse reaction in dividend cut than postponing or even abandoning the share buyback program. So, rather than pay out larger dividends during periods of excess profitability then have to reduce them during leaner times, companies prefer to pay out a conservative portion of their earnings, perhaps half, with the aim of maintaining an acceptable level of dividend cover.

Aside from paying out free cash flow, repurchases may also be used to signal and/or take advantage of undervaluation. If a firm’s manager believes his firm’s stock is currently trading below its intrinsic value he may consider repurchases. An open market repurchase, whereby no premium is paid on top of current market price offers a potentially profitable investment for the manager. That is, he may repurchase the currently undervalued shares, wait for the market to correct the undervaluation whereby prices increases to the intrinsic value of the equity, and re issue them at a profit. Alternatively, he may undertake a fixed price tender offer, whereby a premium is often offered over current market price, sending a strong signal to the market that he believes the firms equity is undervalued, proven by the fact that he is willing to pay above market price to repurchase the shares.

Another reason why executives, in particular, may prefer share buybacks is that executive compensation is often tied to executives’ ability to meet earnings per share targets. In companies where there are few opportunities for organic growth, share repurchases may represent one of the few ways of improving earnings per share in order to meet targets. Therefore, safeguards should be in place to ensure that increasing earnings per share in this way will not affect executive or managerial rewards, even though this does not always occur. Furthermore, increasing earnings per share does not equate to increase in shareholders value. This investment ratio is influenced by accounting policy choices and fails to take into account the cost of capital and future cash flows, which are the determinants of shareholder value.

Share repurchases avoid the accumulation of excessive amounts of cash in the corporation. Companies with strong cash generation and limited needs for capital spending will accumulate cash on the balance sheet, which makes the company a more attractive target for takeover, since the cash can be used to pay down the debt incurred to carry out the acquisition. Anti-takeover strategies therefore often include maintaining a lean cash position, and at the same time the share repurchases bolster the stock price, making a takeover more expensive.