What Is a Share Buyback and How Does It Work?

As investing jargon goes, a share buyback is one of the simplest terms. Let’s break down what it is and how it works.

What is a share buyback?

A share buyback is simply a company buying back its own shares. It can do this in one of two ways:

1. The most common is for a company to buy shares on the open market, just as a private investor does when they buy shares through a broker. A company must get authority from its shareholders in order to buy back its shares. Usually, this is done at its Annual General Meeting.

2. Far less common, is for a company to announce a tender offer. This involves all shareholders submitting a price they would be prepared to accept for their shares. 

In both instances, once the company performs a buyback, it cancels the repurchased shares, so they cease to exist. Therefore, a company cannot flog the same shares back onto the stock market at a later date.

Why would a company buy back its own shares?

A company exists to allocate its resources in the most efficient manner for the benefit of its shareholders. Part of its resources may be surplus cash. Surplus cash is money the company does not require to maintain or expand its business.

The company may decide to return this cash to its investors. This can be done either by a dividend or by buying back its shares. The decision as to which method is used usually depends on complex taxation issues that we can happily leave to the company’s accountants.

In recent years there has been increased pressure from investment institutions for companies to return their surplus cash rather than sitting on it just in case they might need it for future acquisitions. The institutions argue that it should be their decision, and not the company’s, to hold part of their assets in cash.

How do share buybacks work?

Let’s say our company makes £10m in profits each year, of which £1m comes from interest on its cash pile of £30m. It has 100m shares in issue. Therefore, its earnings per share (EPS) is 10p (£10m/100m).

Let’s also assume that the share price is 200p, meaning that investors have awarded the company a price-to-earnings (P/E) ratio of 20 times (200p/10p). So what happens if the company uses all of its £30m in cash to buy back its shares?

In total, it can buy 15m shares (£30m/200p). Because it no longer receives interest on its cash balance, its profits will fall to £9m. These profits will be split between the remaining 85m shares. Therefore, its EPS will rise to 10.6p (£9m/85m).

Investor reaction

Assuming that investors still think a P/E ratio of 20 times is appropriate, they might be willing to pay 212p for the remaining issued shares.

In practice, however, they might be willing to pay even more. That’s because the company’s profits will grow faster now that the slow-growing cash element has been taken out.

But they may also perceive that the company does not have great growth prospects because it cannot profitably invest its £30m spare cash. In that case, they might be willing to pay less. So although the price should move higher in theory, the actual outcome will also depend on how the market perceives the slimmed-down company.

Equilibrium price

It’s worth noting that the cheaper the shares — that is, the lower the P/E ratio — the greater the increase in EPS caused by the buyback. Had the share price been 100p, the £9m in profits would have been carved between just 70m remaining shares, resulting in EPS of 12.9p.

Had the shares been valued at 300p, EPS would have remained at 10p, as the £9m in profits would have split between 90m remaining shares. You could have worked out this ‘equilibrium’ price by noting that, at 300p, the P/E ratio is 30. This number is the same as the £30m cash pile divided by the annual interest of £1m.

So, a company is much more likely to buy back shares when it sits on a low P/E ratio. As it also needs a lot of surplus cash to make a buyback worthwhile, it is much more likely to be mature businesses that buy back their shares.

How do buybacks affect share price?

When a company repurchases and cancels its own stock, the total number of outstanding shares decreases. With fewer shares available on the stock market, all remaining shares gain a larger claim on the firm’s profits.

In other words, all remaining shares become more valuable, sending the stock price up.

Are share buybacks good for investors?

In ideal circumstances, share buybacks are good for shareholders. Technically, profits may see a small impact from the loss of interest earned on the group’s cash balance. But the larger claim on profit more than makes up for this downside.

Having said that, in some instances, the decision to buy back shares can actually be harmful.

Like paying a dividend, a stock buyback is a method of returning excess capital to investors. Yet, in reality, it’s quite common to see management teams commit to share repurchase programmes despite there being a better use for these resources, such as paying down debt.

Furthermore, suppose management doesn’t have a good grasp on the intrinsic value of the underlying company. In that case, they may end up buying back shares at an overvalued price. In this instance, buying back shares can destroy shareholder value rather than create it.

Are share buybacks taxable?

For shareholders, buybacks aren’t directly taxable like dividends. However, when an investor eventually sells some shares, capital gains tax still enters the picture. As a consequence, any gains made through the buyback will eventually get taxed.

This makes share buybacks effectively a tax-deferred method of returning capital to shareholders. However, for UK investors making use of tax-efficient accounts like a Stocks and Shares ISA or Self Invested Personal Pension (SIPP), capital gains taxes can be avoided.

Do you have to sell your shares in a buyback?

If a business is buying back shares from the open market, existing shareholders don’t have to sell their shares. However, the story is a little different if the share buyback programme is executed as a tender offer.

In this instance, the company will propose a specific price to shareholders to repurchase their shares. The decision to sell back to the company is optional. But in most cases, the purchase won’t go through unless there are enough shareholders onboard with the idea.

Disadvantages of stock repurchases

As wonderful as redistributing wealth is, there are some downsides for investors caused by share buybacks. 

In the short term, buybacks can inflate a stock’s price to give a false sense of momentum. Furthermore, financial metrics linked to the total number of shares outstanding can begin to mislead analysts.

For example, after a buyback, EPS and return on equity will both increase. Without context, this can give the false impression that the business is improving its profitability despite nothing actually changing. As a consequence, wrong assumptions are made during analysis that could result in an investor buying a mediocre company dressed up as a high-quality business.