Buyback is a process when an issuer repurchases its own outstanding shares either directly from its shareholders or on the open market. It should be noted that the process of repurchasing can be done with the company’s own money or with borrowed funds. With the current low interest rates in the US, buybacks are often financed with loans since borrowed money has become very cheap. Many believe that this factor has triggered a wave of buybacks.

What can a company do with its cash?

The purpose of all the business activities in any company is to generate net profit that can be distributed by its management in a number of ways. What options does a company have?

- The First Option is to use the money for expansion. While it seems the most logical thing to do, such a decision, however, requires a favorable economic environment. In other words, this should be done when the economic cycle is in a phase with increased demand. Otherwise, additional volumes of goods or services will remain unsold, which means that the money will be wasted. Right now businesses are very cautious about investing in their growth as there are concerns about the future of the economy, so not a lot of companies want to risk those types of large investments.

- The Second Option is for a business to use those free funds to acquire smaller competitors. In this case, they should have a worthy candidate in view.

- The Third Option is to distribute net profit as dividends. But keep in mind that this should be implemented as a long-term strategy. Dividend yield cannot be steeply increased or decreased as it can result in volatility of the company’s stock prices. It should be noted that for companies where most of the capital belongs to a small group of investors, a sudden change in dividend policy will not trigger significant negative consequences.

- The Fourth Option is the stock buyback that has gained immense popularity in the United States as a way of distributing the company’s profits. Buyback allows the company to return money directly to its shareholders and then they can decide what to do with their money. Many believe that buyback is a sign of business maturity because, on the one hand, the company has reached such a level that it does not need to invest all of its available funds in expansion. On the other hand, buyback increases the appeal of its shares for the shareholders by maintaining the share price at a good level.

What happens to the shares?

The repurchased shares are now on the company’s balance sheet and there are two possible options of what the company can do with them.

  1. Cancel the shares. This option is preferable for shareholders as the EPS (Earnings per Share) multiplier starts to go up as the number of shares decreases. The shares now have more appeal and their price increases.
  2. The repurchased shares can be used to reward the company employees as part of an incentive program. Shares can also be used as partial payment for the takeover of other companies and as soon as the share price rises they can be returned to the market.

 The main benefits of a buyback for the company

  1. After the buyback the company will be paying less dividends
  2. It protects the company from a change in ownership
  3. Incentive payments increase
  4. Corporate restructuring through buyback

Reasons for buyback

First of all, the company conducts a buyback if it is profitable for the company. As a rule, the company’s stock price goes up after a buyback. The EPS (Earnings per Share) multiplier rises as the number of shares decreases making the shares more attractive. Their price begins to go up as well, which motivates investors to buy more shares.

 There is also a private type of buyback where the shares are repurchased by the company’s senior manager. For example, this was the way a Russian conglomerate AFK Sistema increased its investors’ confidence in its shares in February 2019, thereby stimulating the stock’s price. Tax optimization is the primary reason for conducting buybacks in the United States because investors pay a higher tax on their dividends than on the exchange rate difference when selling and buying shares.

Examples of buybacks

The heyday of shares buyback was during the crisis of 1987. At that time, administrative conditions were being actively improved while the taxes were lowered in order for companies to be able to buy back their shares to maintain share prices in those difficult times.

The buybacks were also used quite often in China and in the United States in 2007 to buy securities and thereby stimulate market growth. That is, a buyback is one of the stimulating methods that was used along with the stimulating policy of the Central Bank.

Apple has been conducting aggressive buybacks since 2012 continually pumping its share price. Meanwhile, Microsoft is launching a buyback program that does not have an expiration date. Statistics show that since 2013, US companies conducted over $4-trillion-worth of buyback transactions.

Will the company’s stock price increase after the buyback?

Often, the company’s stock does go up but there are still a number of factors that can affect its price: the company’s revenue, profit, its operating activities and financial indicators, the amount paid out in dividends, the number of minority shareholders, the cost of raw materials, the exchange rate at the moment, and the percentage of the repurchased shares. It’s also important to know whether the company is going to purchase securities at a premium and if so, what it is. In this case, buying shares before the buyback will provide an opportunity for profit. One of the main factors is the company’s purpose for the buyback. When a company repurchases its shares and redistributes them among employees, the stock price will be impacted indirectly, while in the case of canceled shares the stock price will definitely increase.