What are share buybacks?

When a company repurchases some of its shares from shareholders, the process is known as a share buyback. Let's explore.

A woman stands on the roof of a city building as papers fly in the sky around her.

Image source: Getty Images

A share buyback occurs when a company repurchases some of its shares from shareholders. The company then cancels the repurchased shares, reducing the number of outstanding shares on issue. A share repurchase reduces the amount of a company's share capital. 

All things being equal, this should boost shareholder returns because the company's profits will be spread across fewer shares. For this reason, share prices often rise after a share buyback program is announced.

Why conduct a buyback?

ASX companies may undertake a share buyback when they have excess capital, so the process is a form of capital management. This is an alternative to paying a larger dividend

A stock buyback results in fewer shares on issue, so it can increase earnings per share (EPS), which in turn can lower the company's price-to-earnings (P/E) ratio.  This may lift the stock price for the remaining shares trading on the market. 

Companies can conduct two types of share buybacks: On-market by purchasing the shares on the ASX, or off-market via a tender process conducted directly with shareholders. Investors can choose whether to participate in a buyback program. 

For an off-market buyback, shareholders can participate by following the directions provided by the company. For an on-market buyback, shareholders can simply sell their shares on the ASX. The buyer may or may not be the company itself. 

What's the difference between a dividend and a share buyback?

Both share buybacks and dividend payments are ways for companies to distribute cash to shareholders. While a dividend returns money to all shareholders, a share buyback returns cash only to those who choose to participate. Both dividends and share buybacks can help increase the overall return from your shares, but there is debate over which is better for investors and companies in the long term. 

Dividends are profits paid to shareholders, providing an instant return (and tax liability). A share buyback reduces the number of shares on issue, which should lead to an increase in the share price over the long term.

But any capital gain is only realised when an investor sells the shares. Of course, this also means that any tax payable on the increase in value is deferred until the shares are sold.

When would a company repurchase its shares?

There are many reasons why companies choose to repurchase shares. It may be because management believes the shares are undervalued, to improve financial ratios, or to consolidate ownership. Share repurchases are a way of distributing excess capital in accordance with stock exchange regulations. 

Shareholders generally demand a return on their investment, so new equity capital can become burdensome. When a company has limited growth opportunities, it may have little reason to deploy excess equity capital, so repurchasing shares can effectively reduce the overall cost of capital. 

Buying shares back can help buoy share prices. For this reason, they are popular with companies that consider their shares to be undervalued.

Shares may be undervalued for several reasons, from short-term adverse impacts to general negative sentiment. When management believes shares are undervalued, the company may choose to invest in itself via a share buyback, thereby seeking to capitalise when market values normalise. 

A share buyback improves financial metrics such as return on equity, so it can help enhance share price valuations. Additionally, it is less likely that there will be an adverse share price reaction if a company chooses to reduce its level of share buybacks compared to cutting its dividend. 

Share buybacks can also signal that a company is financially healthy, with management confident in reinvesting in itself. Generally viewed positively, share buyback announcements can lead to an influx of investors, thereby supporting the share price.

Which companies have conducted buybacks?

Many of the world's largest companies have undertaken share buybacks. Technology giants such as Apple Inc and Alphabet Inc conducted significant buybacks, with Apple reducing its share count by about 39% over a decade.1 

Warren Buffett's Berkshire Hathaway Inc has long favoured share buybacks over dividends. The company hasn't paid a dividend since the 1960s. 

ASX shares have also seen buyback action in the last couple of years, with Commonwealth Bank of Australia (ASX: CBA) announcing a $6 billion off-market share buyback in 2021 and another $2 billion buyback in 2022.

Off-market share buybacks can be tax-effective to return franking credits to shareholders. CBA's buyback had both a capital and dividend component, which allowed investors to take advantage of franking credits. 

CBA could conduct its share buybacks thanks to a strong capital position, which allowed it to return a portion of surplus capital to shareholders.

Other ASX companies that conducted major share buybacks in 2022 included National Australia Bank Ltd (ASX: NAB), Qantas Airways Ltd (ASX: QAN), BlueScope Steel Limited (ASX: BSL), Santos Ltd (ASX: STO), and Whitehaven Coal Ltd (ASX: WHC).2

Are there any downsides?

The returns from share buybacks are far from guaranteed. If a company experiences difficulties after a share buyback, shareholders may not see the share price increase as anticipated.

On the other hand, share buybacks can boost earnings per share, even for low-growth companies. This can result in higher valuations, pushing up the share price. 

Finally, if a company borrows money to repurchase its shares, a share buyback can impact its credit rating. Debt obligations can act as a drain on cash reserves if economic circumstances move against the company. Due to this, downgrades in credit ratings can follow debt-financed share buybacks. 

So, should you participate in a share buyback?

This will depend on the buyback terms, your financial situation, and your opinion about the company's future performance. 

When assessing whether to participate in a share buyback, some factors to consider include the offer price, how the buyback is funded, and any associated tax liabilities for you. Ultimately, the decision is individual to each shareholder.

Article Sources

This article contains general educational content only and does not take into account your personal financial situation. Before investing, your individual circumstances should be considered, and you may need to seek independent financial advice.

To the best of our knowledge, all information in this article is accurate as of time of posting. In our educational articles, a 'top share' is always defined by the largest market cap at the time of last update. On this page, neither the author nor The Motley Fool have chosen a 'top share' by personal opinion.

As always, remember that when investing, the value of your investment may rise or fall, and your capital is at risk.

Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Motley Fool contributor Katherine O'Brien has positions in Alphabet and Apple. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has positions in and has recommended Alphabet, Apple, and Berkshire Hathaway. The Motley Fool Australia's parent company Motley Fool Holdings Inc. has recommended the following options: long March 2023 $120 calls on Apple and short March 2023 $130 calls on Apple. The Motley Fool Australia has recommended Alphabet, Apple, and Berkshire Hathaway. The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.