Public firms that are profitable often give back the excess cash to their stockholders by giving dividends. But they can also give some reward to their shareholders in another manner. This can be in the form of share repurchase programs known as the buyback of shares. The buyback of shares happens when any public firm utilizes its cash to purchase shares of its own stock in the financial markets. Any firm may do this to give back money to the stockholders that it does not require to fund its operations and various other investments. In the buyback of shares, a firm buys its shares of stock on the secondary market from an investor that wants to sell their shares. No shareholder is under any compulsion to sell their shares back to the firm.
The buyback of shares is not aimed at any one group of holders. Any person can participate in it. The public firms that make up their mind to do a buyback of shares usually issue a statement that their board of directors has given authorization for repurchase. It outlines how much money will be given to the whole process of buying back. It can also talk about the percentage of shares or the number of shares outstanding that it wants to buyback.
The primary reason firms buy back shares is done by firms to create more value for their own stockholders. In this case, the value indicates an increase in the prices of the shares. Whenever a demand arises for the firm's shares, the price of the shares increases. When a firm purchases its own shares, it assists in growing the cost of the share by increasing the demand. This creates more value for all the stockholders. One of the top aims of corporate America is to increase shareholder value to the maximum. Because of this principle, a firm should always attempt to give the highest possible returns to its investors. Firms look to achieve this aim by returning cash to their shareholders in the form of dividends and growing the value of the shares in the form of buy-backs. The payment of dividends is the usual method of giving back cash to the stockholders. But there are some benefits to the buy back of shares also.
One of the advantages is that it directly increases the prices of the stocks. The primary aim of any buy back of shares is to give a greater price to the shares. The firm's board may feel that the firm's shares are undervalued. This makes it a great time to purchase them. Also, the investors may see the buy back of shares as a sign of confidence by the management. A firm will not want to purchase its shares if it thinks the value will decline. The payments of dividends are also taxed as income. But the increase in the price of shares is not taxed at all. The shareholders who sell their stocks back to the firm may see a capital gains tax. But the investors who do not sell their shares get the reward of a greater value on the shares with no extra tax.
The buyback of shares also gives greater flexibility than dividends. Any firm that starts a new dividend or grows a current dividend will continue to make payments over the long term. This is because there is less risk of low values of the shares and any unhappy shareholders if they decrease or remove the dividend in the future. Also, since the buy back of shares is not regular, they are a lot more flexible for the management to implement. The method is also a great tool to offset dilution. The firms that are growing often find themselves in a race to get talent. Suppose they give stock options to get employees. In that case, the options exercised over a period grow the total number of outstanding shares of the firm. It also dilutes the present stockholders. The buybacks are a method to offset this change.
The method removes a lot of cash for the balance sheet of a firm and decreases the number of outstanding shares. So, they can have a huge impact on the main metrics used by investors to evaluate a public firm. It is vital to find out that once a firm has bought back some of its own stock, they are canceled to permanently decrease the number of outstanding shares. Sometimes, they are even held by the firm as treasury shares. They are not seen as outstanding shares. This has a lot of implications for some critical measures of the financial fundamentals of a firm. There are important metrics such as earnings per share calculated by dividing the firm's net profit by the number of outstanding shares. Decreasing the number of shares that are outstanding gives higher earnings per share for the firm. This makes the firm appear as if it is performing better. The same thing happens with the price-to-earnings ratio. This assists the investors in finding the relative valuation of the firm by comparing the earnings per share to the price of the shares.
Several people criticize the method of buying back shares. They term it a poor method for firms to create value for their investors. One of the drawbacks is that it makes poor use of cash. This usually depends on a lot of factors. The method may give importance to short-term increases in the prices of the shares when there are other more profitable uses of the cash. Firms can invest in development and research and keep the cash for a critical moment. This will not help increase the prices of the shares, but they will give more value over a longer period. Before the coronavirus pandemic caused havoc in the global economy, nearly half of all bought back shares by taking out debt. The low-interest rates helped the firms to borrow money to spend on this path to increase the prices of their shares in the short term. There are many people who say that this strategy is short-sighted.
Another drawback is that cash-rich firms have high prices for their shares. There are several firms that are opting for this method that have huge amounts of cash after a period of great performance. The firms that create this position also have a high valuation of their shares. This means they may be creating lesser value for stockholders when opting for this method. The final drawback is that it may be utilized to conceal compensation to executives based on stock. There are several public firms that give compensation to managers in the form of shares. This dilutes the other shareholders present. The executives may utilize the buyback of shares to hide how this type of compensation impacts the firm's share count.
Despite all of the points listed above, the buy back of shares can be good for the economics of a firm. But it has an effect on the whole economy also. The buyback of shares can positively affect the overall economy. This is because the method has a much more positive and direct effect on the overall financial economy as they cause an increase in the prices of the stock. But in many ways, the nation's financial economy feeds into the real economy. The reverse also holds true. There has been some research that shows that growth in the financial markets has an effect on the confidence among consumers as well. It increases major purchases and consumption. This is also called the wealth effect.
You may be thinking about what is buy-back of shares and whether it is good for you or not as a retail investor. The method can be positive for investors if the firm is doing well, the shares are undervalued, and there is cash to spare.