What are share buybacks?

What are share buybacks? A share buyback occurs when a company decides to buy some of its shares back from …

What are share buybacks?

A share buyback occurs when a company decides to buy some of its shares back from shareholders. The company then cancels these shares, reducing the total number of shares on issue. 

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 the announcement of a share buyback.

Conducting a share buyback is a form of capital management. ASX companies may choose to do a share buyback when they have surplus capital at hand. This is an alternative to paying a larger dividend. A share 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.

Share buybacks can take place either ‘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 share buyback. 

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 is the difference between a dividend and a share buyback?

Share buybacks and dividends are both ways of distributing cash to shareholders. While a dividend returns cash to all shareholders, a share buyback returns cash only to those shareholders 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 that are 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 such gain is only realised when an investor sells the shares. Of course, this also means that any tax payable on the increase is deferred until shares are sold.

When would a company buy its shares back?

There are many reasons why companies choose to buy back shares. It may be because management believes the shares are undervalued, or to improve financial ratios, or to consolidate ownership. 

Shareholders generally demand a return on their investment, so unused equity capital can become burdensome. Where a company has limited growth opportunities, it may have little opportunity to deploy excess equity capital, so buying shares back can be an effective way of reducing the overall cost of capital. 

Buying shares back can help buoy share prices. For this reason, they are popular with companies that feel they are undervalued. Companies may be undervalued for a number of reasons, from short-term adverse impacts to general negative sentiment. Where 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 improve share price valuations. Additionally, it is less likely that there will be a negative share price reaction if a company chooses to reduce its level of share buybacks compared to cutting its dividend. 

Share buybacks can 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 share buybacks?

Many of the world’s largest companies have undertaken share buybacks. Technology giants such as Apple Inc (NASDAQ: AAPL) and Alphabet Inc (NASDAQ: GOOGL) (NASDAQ: GOOG) conducted buybacks in 2021, with Apple reducing its share count by about 20% since 2016. 

Warren Buffett’s Berkshire Hathaway Inc (NYSE: BRK.A) (NYSE: BRK.B) has long favoured share buybacks over dividends. The company hasn’t paid a dividend since the 1960s. 

ASX shares have also seen buyback action, with Commonwealth Bank of Australia (ASX: CBA) announcing a $6 billion off-market share buyback in 2021. Off-market share buybacks can be a tax-effective way of returning franking credits to shareholders. CBA’s buyback had both a capital and dividend component, which allowed investors to take advantage of franking credits. 

CBA was able to conduct its share buyback thanks to a strong capital position, which allowed it to return a portion of surplus capital to shareholders. Other ASX companies that announced buybacks in 2021 include BlueScope Steel Limited (ASX: BSL), Telstra Corporation Ltd (ASX: TLS), and Suncorp Group Ltd (ASX: SUN).

Are there any downsides to share buybacks?

The returns from share buybacks are far from guaranteed. If a company experiences difficulties subsequent to a share buyback, shareholders may not see the share price increase as they may have 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 adversely 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 terms of the buyback, your own financial situation, and your opinion about the future performance of the company. 

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

Guide last updated 17 December. Suzanne Frey, an executive at Alphabet, is a member of The Motley Fool’s board of directors. Motley Fool contributor Katherine O'Brien owns Alphabet (A shares) and Apple. The Motley Fool Australia's parent company Motley Fool Holdings Inc. owns and has recommended Alphabet (A shares). The Motley Fool Australia owns and has recommended Telstra Corporation Limited. The Motley Fool Australia has recommended Alphabet (A shares), Alphabet (C shares), Apple, and Berkshire Hathaway (B shares). The Motley Fool has a disclosure policy. This article contains general investment advice only (under AFSL 400691). Authorised by Scott Phillips.