Share buybacks by companies are often mentioned as one of the ways companies create wealth for their shareholders, but is this really always the case?
When do companies buy back their shares?
When a company’s business is doing well, it makes a lot of money. The management of the company has to decide what to do with that money, trying to put it to efficient use with the aim of creating the greatest possible wealth for the owners (shareholders). There are various options when it comes to managing this excess liquidity. Each one has its advantages and disadvantages.
Let’s see some of the options that a company’s board of directors has to manage the money earned:
- Keep and accumulate money on the balance sheet.
- Reinvesting in business operations (also called organic growth)
- Acquire other companies (also called inorganic growth).
- reduce debt
- Distribute the money among the shareholders through a dividend.
- Buy back your own shares.
Why is a company’s share buyback said to create shareholder value?
A share represents a piece of ownership in a company. This includes ownership of the company’s assets and liabilities, as well as the corresponding share of all future profits generated by the business, etc.
Let’s see an example:
A company is divided into 100 shares. I own 20 shares; therefore, I own one fifth (20%) of the company. The company decides to repurchase (and redeem, that is, eliminate) 20 shares. From that moment on, the company was made up of 80 shares. I still have my 20 shares, but now I have a quarter (25%) of the company.
This simple example shows that when a firm buys back shares, our ownership increases immediately. When firms buy back and write down their shares, their share of each remaining share increases.
Is there real value creation, or is it just an accounting trick?
A company’s value depends on its future income, making it difficult to calculate. If the company liquidates, its worth can be estimated from its balance sheet. We invest in companies to grow and profit from them, not to shut them down and sell their assets.
From an accounting point of view, there is no generation of value in a repurchase of shares by a company. Although the number of shares decreases, so does the money on the balance sheet, and therefore, if we look only at what appears on the balance sheet, there is no change in value. Let’s look at an example of this:
Its assets total $100 million. My 20 shares represent 20% of the corporation, so I indirectly control 20 million assets.My 25% is worth $20 million if the firm buys back 20%.
As mentioned, a company’s worth depends on its current and future assets. Logically, a company that has 100 million assets on its balance sheet (factories, stocks, etc.) that next year will earn 50 million is not worth the same as another company with 100 million assets that the following year will earn only 10 million. All other things being equal, shareholders will be willing to pay more for the first company than for the second.
Due to this participation component of future profits that is linked to owning the shares of a company, we can say that the reduction in the number of shares of a company generates value for shareholders. As we saw, shareholders will automatically receive a larger share of the company’s future profits since their stake has increased, even if it is not recorded on the balance sheet.
Is it always a good idea to buy back shares in a company?
No. Logically, the value created for shareholders depends in part on the price paid for the shares. The more you pay for the shares, the higher future earnings growth will have to be to offset the money spent buying back the shares. As always, investors must calculate the opportunity cost of an asset and determine whether the price paid for it today is worth the uncertainty of receiving future benefits.
What other alternatives does the company have to reward its shareholders?
Dividends are the most common shareholder compensation. The main negative is dividend taxation.Repurchasing shares after dividends eliminates the tax penalty and is more efficient.Repurchases are a more efficient approach for firms to repay shareholders since they avoid this tax penalty. However, future gains are always uncertain, and some stockholders prefer cash now to a larger proportion of future profits.
In practice, good companies do not have to restrict themselves to just one type of strategy, and most large companies combine all strategies to try to create wealth for their shareholders and satisfy all preferences.