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What is a buyback, and why do companies use it?

In the different specialized financial media, it is common to read that this or that company will make a share buyback. Why does a company buy its shares on the open market? Large companies often use this strategy for different purposes. We will know how this strategy operates and the criticisms that exist to this methodology.

Why do companies resort to share buybacks?

When a company resorts to share buybacks, it does so with one goal: to invest in itself. By making a buyback, a company achieves a reduction in outstanding shares.

What happens when a share buyback is made? As the number of shares on the market is reduced, those that remain represent a larger proportion of the company. The result is that earnings per share will grow.

On the other hand, the buyback of shares allows you to give a course to the accumulated cash that does not generate profits. In this sense, the movement to acquire its shares causes a company a double benefit.

Some companies use this strategy to reward their employees. They carry out the buyback and distribute them among managers and plant personnel of the company. The shares are delivered directly or through options.

When a company decides to buy back shares, it generally uses retained earnings. By doing so, a company causes the same economic effect as paying dividends to shareholders with those profits.Buyback

How does the buyback process work?

The buyback of shares has become a procedure, increasingly common in the stock markets and among large companies. In 2018, Amazon was authorized by its board of directors to have a trillion dollars available for the buyback of shares.

In 2012, Apple accumulated 120 billion dollars in cash that were finally used to buy back shares.

Warren Buffett, the most followed man in the financial markets, uses a portion of his earnings to buy back shares in Berkshire Hathaway. A mechanism that is put into effect when the share price falls to a certain level.

Companies have two ways to buy back shares:

  1. Present to the shareholders a purchase offer for part or all of the outstanding shares. In these cases, companies often offer a premium above the market price. Let’s say this premium is the cost the company pays to get investors to divest their assets.
  2. A company can go directly to the open market to purchase its shares. In some cases, they have the program with a specific schedule.

To finance the buyback of shares, companies can use different ways:

  • Dispose of the accumulated cash
  • Issue debt securities
  • Make regular purchases using cash flow from operations

Extended buyback

The companies carry out the purchase of shares through a plan previously defined by their board of directors. When an increase in share buybacks alters this plan, we speak of extended buybacks.

There is an indicator that allows to establish the impact of the buyback of shares and compare it with other companies. This ratio is calculated by dividing the number of dollars used in the previous year for the buyback by the market capitalization at the beginning of the buyback period.

Observations on the repurchase of shares

Although share buyback is a common and widespread mechanism, there are criticisms of this action.

Acquiring the shares of the company itself can indicate that there are no possibilities for growth in the medium term. This can negatively influence investor sentiment.

The share buyback can be seen as a mechanism to raise the share price artificially. By doing so, companies achieve higher market value. However, the reasons may be far from the fundamentals that show a thriving company.

 

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