Buybacks of Shares

A good company strategy?

Buybacks of shares is the best strategy for companies to employ when the current stock price is less than the calculated fair value of the stock in question.

During market downturns, such as in a recession, an opportunity may arise for companies to purchase some of their own shares on-market and cancel them, hence reducing the overall number of shares on issue.

The effect of less shares means that the future earnings per share is likely to increase - which is a good look for the earnings per share bar graph in the next company report.

Whether this is an appropriate strategy depends on the company's judgement that the stock price is lower than the intrinsic value of the stock.

Types of Offers

While there are generally five types of offers for a buyback of shares, the two types that are most relevant to stockholders are on-market and equal access.

With an equal access offer, all shareholders are offered the opportunity to sell their holding back to the company off market, that is, not through a broker.

These can be made more tax effective by returning some of the payout as a fully franked dividend, which reduces some of the capital-gain burden on stockholders.

The on-market offer is generally made by companies that don't have large franking credit pools. The impact of this strategy should give rise to an increase in the share price.

Buybacks Versus Acquisitions

It makes more sense for a company to use excess funds to reduce the number of company shares when the above situation arises than to use the funds to seek out an acquisition.

The company directors should be in a better position to determine the current stock value of their own company than that of a possible acquisition.

Buying the complete ownership of another company almost ensures that they will pay a full, or more than full price for the entity.

Do sellers of anything ever ask less than what they think their asset is worth? More often they ask more!

If the price at which the company buys back its own shares exceeds the fair value of the stock, shareholders suffer through reduced profitability.

They may also suffer by the depletion of cash reserves, or through increased debt if the company used debt to fund the move.

For some companies, such as listed investment companies (LICs), the fair value of the stock can be readily ascertained by comparing the latest net tangible asset (NTA) figure to the buyback price.

Sometimes companies complain that the market is undervaluing their stock. One might reasonably ask: "Why are they not buying back their shares?"

Creating value and profitability can be as much, if not more about contraction by reducing the number of shares in a company as it can be about expansion through acquisitions.

Stockholders' Perspective

From a stockholder's point of view, an on-market buyback of shares does not need to affect them if they decide not to sell back their stock.

Their only concern is whether the company has correctly commenced the strategy when the stock price was, in the opinion of the stockholder, below the true value of the stock.

If they think otherwise, then their best move may be to take the opportunity to sell their stock because of their loss of confidence in the directors of the company.

If an offer is made off-market, the stockholder needs to decide whether the offer overvalues the stock. In this case, it is also an opportunity to sell.

To Conclude

I try to make a judgement as to whether the company's offer to purchase their own shares is a sensible move by comparing their buying price to my estimate of fair value - that is, what I would pay for the stock from a value investing perspective.

So depending on the price at which the offer is made, stock buyback programs may be a good thing, or not-so-good thing for a value investor.

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