Lots of investors are still confused when they hear XYZ company is buying back its shares from the public. They do not understand what exactly is Share/Stock Buyback/Repurchase.
Please note that all these mean the same thing:
– Share Buyback
– Share Repurchase
– Stock Buyback Share or Stock Buyback or Explained
– Stock Repurchase
Let me first explain in short what exactly is Share Buyback.
A share buyback happens when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously distributed among public and private investors. Once this happens the owners of the public and private investors decrease in the shareholding pattern. One immediate and short term effect of this is that the EPS (Earning Per Share) increases of the company. This increases the valuation of the company in the stock market and may take the price of its share a tad higher.
Since 2010, share buybacks have overtaken dividends as a preferred way to return cash to shareholders. This usually happens with cash-rich companies.
Here a few reasons why companies do share buybacks:
- After huge profits sometimes financial/management restructuring is required. According to stock market laws the management has to declare dividends for their shareholders. If the management sees more benefits in buying back of shares looking at future dividends they do so to keep money with themselves.
- By buying back the shares Earning Per Share (EPS) will increase which is floating in the free market. This leads to an equity value increase, thus more demand for the company shares as the share looks financially attractive. Do not forget that with the share price increase the profit of the management also goes up.
- If you look at indirect effect – more money with management means in future they can expand the company. This generates employment which is good for the economy of the country.
Is there any downside of share buybacks?
Yes, mostly share buybacks are financed via a loan or debt. This can affect cash flow in a negative way. However, this is short term as the management does due diligence before announcing a share buyback.
Most Important Question that keeps worried a novice investor. Will I be forced to sell my shares to the management?
Answer: No. Who sells a stock and who buys happens at the market place. Suppose in a day 1000 shares were bought and sold of a company then it just that. It’s not one to one selling or buying. It is just that 1000 stockholders sold their stocks to 1000 investors who were interested in buying the shares of that company. Similarly, when news of share buyback is released in the public domain via media/social media by the company in most cases the share prices jumps and investors who are making a profit selling their holdings. So assuming in the above case when other days 1000 shares were sold by investors and bought by the investors, on the share buyback day 1000 shares were sold by investors but out of that let’s say 100 was bought by the management of the company and 900 was bought by the retail investors. Of course just like normal trading days where we do not know who sold and who bought the shares, on this day too it happens in the market place. So no one is forced to sell their shares. If you are not interested in selling just do not place your stocks for a selling order.
What happens after the share buyback?
Suppose only 1000 shares of a company XYZ were floating in the stock markets and 100 shares were bought back by the management then from the T-1 day after the share buyback day, the free float of that company’s shares in the open market will be only 900.
Let me explain in details the share buyback.
Suppose there are 10 people who plan to start a business. They find a place in a good location and start a restaurant. Assuming that they put the same amount of money to open the restaurant, in that case, each one will get 10% of the share of the profits made. Now suppose in the first year of business they made a profit of 10 lakh. 10% of 10 lakh is 1 lakh. Each owner will get 1 lakh at the end of the first profitable financial year.
Similarly in future years also profit’s share will be equally divided among all owners of the restaurant. This is called dividend policy. Each owner gets a dividend as per their shareholding (ownership). No one can claim more or deny the dividend.
Of course, if any owner is not interested in the dividend they can reinvest the money received to buy more shares of the company if they foresee better growth of the company and dividends in the future. How this is done? For the time being, just imagine that every owner got a legal paper stating that the owner will get 10% of the profits every year. Now suppose one owner “A” talks to another owner “B” and offers him some money in return for the ownership of his percentage of share of profits for the rest of the term till the business exists. “B” is interested as he needs money for some work and sells his share to “A”. This is a “buyback policy“.
As you can understand, there are 9 owners of the company now. “A” and “other 8”. Henceforth the “other 8” will get 10% of the profits from the company each year whereas “A” will get 20% of the profits. Likewise, owners who don’t need money when a dividend is declared can do a *share buyback* in exchange for a greater percentage of profit made in the future.
To illustrate this with an example lets now take the same example above. After the share buyback done by “A” the “other 8” owners of the company will still get 1 lakh each but now “A” will get 20% which is 2 lakh. If the company makes more profit in the future “A” will get more profit share than the “other 8”.
Note that company is now making same profit but “A’s” profit share has increased by 100%. So, share buyback helps the owners return increase at a rate higher than what the business is growing at. This must have given you an idea on why owners go for share buybacks.
You must have noticed that 9 out of 10 times share buybacks are done only when a company is performing very well over time and is expected to grow at a faster pace in near future. This is the time owners buyback a portion of shares from retail traders. In other words a share buyback is owners investing in their own company for enjoying more profits in the future.
However the above example is simplified way of share buybacks, with public companies its a bit more complicated. With public companies the process is long – they have to inform to SEBI, check financials, future growth assumption, check the after effects of buyback, free cash flow availability of the company, capital allocation, dilution, and multiple expansion/contraction. Note that the after effect of buybacks in a public company may be different than what they assume therefore share buybacks are done after a lot of research in big companions.
Free Cash Flow (FCF) represents the cash a company generates after accounting for cash outflows to support operations and maintain its capital assets. Unlike earnings or net income, free cash flow is a measure of profitability that excludes the non-cash expenses of the income statement and includes spending on equipment and assets as well as changes in working capital from the balance sheet. Free cash flow is an important measurement since it shows how efficient a company is at generating cash. Free Cash Flow (FCF) is also a major indication of the future price of the stock.
Benefits of Free Cash Flow (FCF): Helps in share buybacks, pay dividends to all stock owners, make acquisitions (of a fast growing company which may become so big in future that it may be a threat to the survival of the company or just another good company), or simply pile up cash on the balance sheet. The management decides how to allocate Free Cash Flow to the possible activates.
Dilution: Dilution occurs when a company issues new shares. This results in a decrease in existing shareholders ownership of the company. For example if a company has 100 shares in the market and issues 10 more shares, then the value of each share goes down by 10%, making each share less valuable.
Stock dilution can also occur when holders of stock options, such as company employees, or holders of other option-able securities exercise their options. It is now possible in India too. Buyback is exactly opposite. The purpose of buybacks is to increase shareholder returns by reducing the number of shares outstanding over time.
But many companies negate a lot of this benefit by simultaneously issuing vast amounts of stock to employees, via share based compensation (SBC). This is also important to retain good employees in the company.
Now the million dollar question – is it wise to invest in a company for the long term (min 10 years) which has a good FCF (Free Cash Flow) and does share buybacks often?
Answer: YES. In my experience a 10% increase YOY in FCF (Free Cash Flow) of the company will lead to approx 15-18% CAGR (Compound Annual Growth Rate) at the end of 10 years. This will make a good investment.
Berkshire Hathaway (CEO: Warren Buffett) uses this formula to chose company to invest for the long term. He has explained in details about this in a letter to the Shareholders of Berkshire Hathaway Inc. on February 25, 2012 – Berkshire’s Corporate Performance vs. the S&P 500.
In short, yes you can invest in company that goes for share buybacks often and has good Free Cash Flow (FCF) and are increasing the FCF year on year.
Hope this post will help you understand share buybacks in a better way. If you have any doubts please do write in the comments section below.
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