Understanding Stock Buybacks: Methods & Impact on Share Value

Stock buyback methods involve reducing the number of shares outstanding and raising the price for the remaining shares. Similar to dividend payments, stock buybacks can be used to distribute invested capital back to the shareholders.

What is a Stock Buyback?

A stock buyback (also known as a share repurchase) is a financial transaction in which a company repurchases its previously issued shares from the market using cash. Since a company cannot be its own shareholders, repurchased shares are either canceled or are held in the company’s treasury. Either way, the shares are no longer eligible for dividend paymentsDividend PolicyA company’s dividend policy dictates the amount of dividends paid out by the company to its shareholders and the frequency with which the dividends are paid and lose their voting power.

Summary

• A stock buyback occurs when a company buys back all or part of its shares from the shareholders.
• Common reasons for a stock buyback include signaling that the company’s stock is undervalued, leveraging tax efficiency, absorbing the excess of the shares outstanding, and defending from a hostile takeover.
• Open market buybacks, fixed price tender offer, Dutch auction tender offer, and direct negotiation with the shareholders are four methods of stock buybacks.

Reasons for a Stock Buyback

Some reasons that urge a company to initiate a stock buyback include the following:

1. To signal that a stock is undervalued

If a company’s management believes that the company’s stock is undervalued, they may decide to buy back some of its shares from the market to increase the price of the remaining shares.

2. To distribute capital to shareholders with a high degree of flexibility in the amount and time

Dividend payments do not provide much flexibility to the company’s management since they must be paid on certain dates, and all common shareholders must be paid. On the other hand, stock buybacks generally provide a high degree of flexibility since they do not specify the amounts that must be paid or dates when the transactions must occur.

3. To take advantage of tax benefits

Stock buybacks can be a great alternative to dividend cash payments in countries in which the capital gain tax rate (money that shareholders receive from the stock buyback are treated as capital gains) is lower than the dividend tax rate.

4. To absorb the increases in the number of shares outstanding due to the exercise of stock options

Companies that offer stock options as a part of compensation packages to its employees commonly initiate stock buybacks. The rationale behind the practice is that when the company’s employees exercise their stock options, the number of shares outstanding increases. In order to maintain optimal levels of shares outstanding, a company buys back some of the shares from the market.

5. To use as a hostile takeover defense

If there is a threat of a hostile takeoverHostile TakeoverA hostile takeover, in mergers and acquisitions (M&A), is the acquisition of a target company by another company (referred to as the acquirer) by going directly to the target company’s shareholders, either by making a tender offer or through a proxy vote. The difference between a hostile and a friendly, the management of a target company can buy back some of its shares from the market as a defense strategy. The goal of the defense strategy is to diminish the acquirer’s chances of obtaining a controlling interest in the target company.

Methods of Stock Buybacks

Generally, a stock buyback can be undertaken using open market operations, a fixed price tender offer, a Dutch auction tender offer, or direct negotiation with shareholders.

1. Open market stock buyback

A company buys back its shares directly from the market. The transactions are executed via the company’s brokers. The buyback of shares generally happens over a long period of time as a large number of shares must be bought. At the same time, unlike other methods, stock buybacks via open market do not impose any legal obligations on a company to complete the buyback program.

Thus, a company enjoys the flexibility to cancel the stock buyback program at any time. The primary advantage of the open market stock buyback is its cost-effectiveness because a company buys back its shares at the current market price and doesn’t need to pay a premium.

2. Fixed-price tender offer

A company makes a tender offer to the shareholders to buy back the shares on a fixed date and at a fixed price. The price of the tender offer almost always includes a premium relative to the current share price. Then, those shareholders who are interested in selling their stocks submit their number of shares for sale to the company. Generally, a fixed price tender offer can allow completing a stock buyback within a short period of time.

3. Dutch auction tender offer

In a Dutch auction, a company makes a tender offer to the shareholders to buy back shares and provides a range of possible prices, with setting the minimum price of a range above the current market price. Then, the shareholders make their bids by specifying the number of shares and the minimum price at which they are willing to sell their shares. A company reviews the bids received from the shareholders and determines the suitable price within a previously specified price range to complete the buyback program.

The main advantage of the Dutch auction is that it allows a company to identify the buyback price directly from shareholders. Additionally, using such a method, the stock buyback program can be completed within a relatively short time frame.

4. Direct negotiation

A company directly approaches one or several large shareholders to buy back the company’s shares from them. In such a scenario, the purchase price of the shares includes a premium. Note that the key benefit of this method is that a company can negotiate the buyback price directly with a shareholder. Due to this reason, this method can be highly cost-effective under certain conditions. However, direct negotiations with shareholders can also be time-consuming.

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