Companies can distribute cash to their stockholders through a share repurchase, but for these to be effective, share buybacks have to be done at the right time and for the right reasons.
Share buybacks are one way stockholders can cash in on an investment, but anyone considering selling their holdings should try to understand why a company is choosing to buy back stock and how that move may affect its future prospects.
According to Robert Stammers, director of investor education for the CFA Institute, share buybacks can be beneficial, but whether you win or lose when presented with a tender offer will partly depend on the state of the company’s balance sheet and its growth prospects.
Here are some of the key things you need to know about stock repurchases:
What’s a Share Buyback?
A share buyback or repurchase is when a company puts out a tender offer telling shareholders it’s willing to buy back its own shares at a certain price. That price is usually higher than what the stock is currently trading at. Shareholders can then submit written offers, which the company can accept or reject, as it tries to buy back its own stock at the lowest price.
Share buybacks can also be done on the open market, but it’s not the preferred option for most companies since this has a tendency to increase the share price.
“If a company announces that they’re going to buy back shares, very often the price jumps because (it’s seen as a sign) that the company believes the stock is undervalued,” Stammers said.
Why Would a Company Buy Back its Shares?
While there are several reasons why a company might repurchase its shares, the only reason it should is if its leadership actually does believe that the shares are undervalued.
“If it’s the other way around, it’ll be detrimental to the existing shareholders,” said Stammers.
But companies can also opt to buy back shares to reduce their cost of capital. That’s because a company’s capital structure is made up of equity, debt and existing cash. This cash from operations is the cheapest source of capital, but it’s also money the company may need for ongoing operations and growth. Debt is the second cheapest form of capital the company has, followed by equity – the company’s shares – which is the most expensive.
“Sometimes, if they repurchase their shares, especially if their shares are undervalued, they can reduce their cost of capital and get a more preferred capital structure,” said Stammers.
“It’s also a way to give shareholders cash other than a dividend.”
A company may also be tempted to buy back shares if it feels its stock is being unfairly beaten down in the market and wants to stop the losses.
Or, a company may repurchase to make its financial ratios look better, given that buying back shares will reduce the earnings per share but increase the price earning, or P/E, ratio. This can also increase the company’s return on equity because there’s less equity.
Whether investors benefit from a repurchase or not will depend on a number of factors, including when they sell, for how much, and what’s motivating the company to do the repurchase.
Stammers points to the example of Netflix, the Internet streaming service.
In 2007, Netflix had no debt on its balance sheet and the company decided to borrow $100 million to buy back its shares.
This reduced the cost of capital because it turned equity into debt, which is a cheaper form of capital.
“They believed their shares were undervalued and they bought it at around $21 and from that point the stock started rising,” he said.
“I think eventually it went up to about $300.”
From the outside, that looked like a good share repurchase because Netflix took expensive equity and turned it into much less expensive debt, while also securing extra cash that was used for growth. And for a while, it was.
The company continued to do buybacks because it had extra cash, and that was great for shareholders – to a point.
“They weren’t great for people that sold their stock back (early on) because the stock went up in price,” said Stammers.
“But in 2011, Netflix was still buying back stock at around $217 … (when it) started to raise its prices on its streaming services (…) lost all these customers (and found it) didn’t have enough cash for growth.”
By 2016, the stock was trading below $95, so all those shareholders that stayed in lost the opportunity to sell at $217.
“A share repurchase that’s done correctly (and) is good for the company, is good for the shareholders that stay at the detriment of those who sell their shares. There’s an opportunity cost,” Stammers said.
“Conversely, a bad stock repurchase, or one that’s done for the wrong reasons or incorrectly is at the detriment of the existing shareholders (versus) the ones who sold.”
What can Investors do if They’re Presented With a Tender Offer?
Figuring out when to sell or hold an investment is one of the more difficult decisions you’ll have to make. And as an investor, you should never try to time the market.
But when you are presented with a share repurchase, such as the case of Netflix, what you can do is consider whether you still believe in the company, said Stammers. He added that you should ask yourself if you think it has room to grow past the amount the current leadership is willing to pay you for your shares.
“If you thought that they were doing it incorrectly or it wasn’t a good idea, then you should sell your shares to the company and get out.”
You can also opt to sell back just some of your shares.
But any time you are presented with this kind of decision, it’s best to talk it through with a financial advisor, who can help you decide whether selling is in your best interest – and if so, at what price.