Listed companies reward their shareholders with a portion of their profits. Cash dividends are the most common form of this reward. However, some companies’ shareholder remuneration offers an alternative: share buyback. NMTBP explores share buybacks and their benefits

What is a share buyback?

A share buyback is when companies buy back their own shares from the market, cancel them and, ultimately, reduce share capital. With fewer shares in circulation, each shareholder gets a larger stake in the company and a higher return on future dividends

Why would a company buy back its shares?

A company exists to allocate its resources in the most efficient manner for the benefit of its shareholders. Part of its resources may be surplus cash. Surplus cash is money the company doesn’t, in theory, require to maintain or expand its business

The company may decide to return this cash to its investors. This can be done by either a dividend or buying back its shares. The decision as to which method is used usually depends on complex taxation issues that we can happily leave to the company’s accountants

In recent years, there has been increased pressure from investment institutions for companies to return their surplus cash rather than sit on it just in case they need it for future acquisitions. The institutions argue that it should be their decision, and not the company’s, to hold part of their assets in cash

What are the benefits of a share buyback?

Here are some of the ways that buybacks work to shareholders’ advantage under normal market conditions:

• First, the share price will increase since the company’s value remains the same but the supply of shares is lower. However, that depends on market behaviour
• Second, the earnings per share (EPS) should increase because fewer shares are in circulation. Shareholders will have a greater stake in the company’s profits
• Third, unless a shareholder chooses to offload their shares, a buyback is a tax-free transaction

Share buybacks enable companies to raise shareholder value. Under normal market conditions, the portion of profits a company uses to buy back shares should strengthen its share price

Imagine a listed company with 1,000 shares, and 100 (10%) of them are held by one shareholder. The company runs a share buyback programme and purchases 100 shares, reducing total share capital to 900 shares. The shareholder, whose stake has increased by 1.11% to 11.11%, is now entitled to more of the company’s profits. Also, the share price should become more attractive to investors

Do you have to sell your shares in a buyback?

Existing shareholders don’t have to sell their shares if a business buys back shares from the open market. However, the story is slightly different if the share buyback programme is executed as a tender offer. In this instance, the company will propose a specific price to shareholders to repurchase their shares. The decision to sell back to the company is optional. But in most cases, the purchase won’t go through unless enough shareholders are on board with the idea

Disadvantages of share buybacks

As wonderful as redistributing wealth is, there are some downsides for investors caused by share buybacks

In the short term, buybacks can inflate a share’s price to give a false sense of momentum. Furthermore, financial metrics linked to the total number of shares outstanding can begin to mislead analysts

For example, after a buyback, EPS and return on equity (ROE) will increase. Without context, this can give the false impression that the business is improving its profitability despite nothing actually changing. Consequently, wrong assumptions are made during analysis that could result in an investor buying a mediocre company dressed up as a high-quality business