When purchasing its own shares, an organization buys its own shares on the stock exchange. This ensures that the number of outstanding shares on the stock exchange decreases.
This transaction creates various opportunities and risks. Depending on the price and situation, share buybacks can generate or destroy a lot of value.
In this article I will discuss:
- Meaning share buyback
- Advantages of buying back own shares
- Disadvantages of buying back own shares
- Purchase of own shares vs dividend
- Influence of taxes
- Interpretation of share buybacks
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Share buyback
Meaning share buyback
A company can decide to buy back its own shares. A company then buys shares from shareholders. These shareholders receive money and the organization receives the shares. This means that the remaining shareholders have less cash in the organization, but the number of outstanding shares has decreased. The remaining shareholders therefore have a greater interest in the company.
Advantages of buying back own shares
Buying back shares has both advantages and disadvantages. Which prevail depends, among other things, on the price at which own shares are bought. The main advantages are:
- Fewer Shares Outstanding / Higher Percent Ownership of the Company: The biggest benefit of buying back your own shares is that fewer shares are outstanding after the buyback. This means that the permanent shareholders own a larger share of the company.
- Destroy shares: The permanent shareholders become owners of the shares that are now owned by the company through the share in the company. Whether an organization subsequently decides to hold or destroy these shares should in itself make no difference. Yet investors often like to see the shares destroyed. This is because companies are more likely to issue shares that have been repurchased than destroyed shares. Shareholders generally do not want the interest in the company to be diluted by the issue of shares. Shredding stock makes this less likely and so is often preferred despite it shouldn’t matter economically.
- Greater Share of Profits: A greater stake in a company has several benefits. For example, the profit has to be divided over fewer shares and thus the profit per share often increases. After the purchase of shares, the permanent shareholders are entitled to a larger share of the future profits.
- Ability to increase the dividend: Fewer shares outstanding also means that the costs for the same dividend per share are lower. So companies can choose to increase the dividend per share without incurring higher costs. This ensures that the dividend per share may increase.
Disadvantages of the share buyback
The disadvantages of the share buyback mainly arise from the costs of the purchase. Stock repurchases are usually done in exchange for money and this pushes down the amount of cash.
- Decline in equity: The purchased shares are exchanged for cash and this pushes equity down. Some organizations also borrow money to buy back shares. In both cases, equity falls and reserves fall. This gives the organization less scope to deal with setbacks internally. The chance that the company will have to return to the capital markets for this is therefore increasing.
- Less money left for business investments:The outgoing cash cannot be spent on other activities. A possible danger is that companies invest less in the future and spend too much on the purchase of their own shares in order to boost earnings per share. This means that permanent shareholders acquire an increasing interest in an increasingly less valuable company. A lack of investment can also have other negative effects such as less growth opportunities for the workforce and a weakened competitive position. When own shares are bought back, shareholders must therefore think carefully about the consequences and risks. This is because management may only buy back shares to drive up the price of options issued in the short term.
Buying own shares vs paying a dividend?
Dividend and share buyback are both capital returns. In the case of a dividend, the capital goes proportionally to all shareholders, while in the case of share repurchases, the money goes to the shareholders who leave the company. The shareholders who continue to be rewarded with a higher percentage ownership of the company. Shareholders generally believe the stock is a good buy. Otherwise, they probably wouldn’t have the shares themselves. However, this does not mean that these shareholders are always right. If the situation changes and the company goes down, then buying back its own shares afterwards is a stupid decision. If the situation improves, then buying own shares is a genius decision.
Shareholders can create their own dividend by selling shares. By selling a small portion of the shares you can also ensure that your interest in a company remains the same while the company is buying back shares.
Effects of Taxes
How money is distributed to shareholders affects the taxes that must be paid. Many countries have a dividend tax. This means that some of the dividends paid go into the pockets of the government. When companies distribute money through share buybacks, shareholders usually do not have to pay anything in the first instance. Should the share price be inflated, a portion of the profit must be paid in some countries when sold. The difference in timing when the tax is due makes share buybacks more attractive. In addition, the amount of the dividend tax and capital gains tax can have a significant influence on the choice.
Finally, the way companies are taxed also makes a difference. In some countries, companies are taxed extra when they buy back shares. Changes in these types of taxes can greatly affect how companies return capital to shareholders.
Interpretation of share buybacks?
Whether the share buyback is a good decision depends to a large extent on the future of the company. If the company gets into trouble, money is needed and money may have to be raised on unfavorable terms. However, if everything goes according to plan, the share buyback is an attractive way for long-term shareholders to expand their stake.
Another factor is not the company’s success, but its appreciation. How many shares you can buy back for a certain amount of cash has a lot of influence on the success of buying your own shares.
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