Share buybacks can be appealing to investors in a handful of different scenarios. Here’s a look at what they are and why they’re important.
Share buybacks smashed historical records last year, and new investors might be wondering: What are buybacks? What do they mean, and why are they important?
A share buyback occurs when a company repurchases outstanding shares in order to reduce the number of shares it has on the market. Companies can take this step as a way to increase the value of available shares through reducing supply, or as a way of decreasing the possibility of shareholders taking a controlling stake in the company.
To put it another way, a buyback is a way for a company to invest in itself. When a buyback happens, shareholders may receive an offer that gives them the option to submit a portion or all of their shares for reimbursement at a premium to the current market price. Alternatively, the company may buy back its own shares on the open market over time.
In 2018, announced stock buybacks reached a record $1.1 trillion by mid-December with approximately $800 billion of that having been purchased, according to CNBC. Share repurchase programs have only been permitted in the US since 1982, and since then, there has been a steady increase in the number of buybacks among S&P 500 (INDEXSP:.INX) companies.
Why investors want buybacks
Share buybacks can be appealing to investors in a handful of different scenarios. In one common instance, it can be a signal that a company has excess cash on hand, giving shareholders reassurance with regards to that company’s cash flow status.
“For starters, they’re a sign that the company won’t be doing something wasteful with that excess cash — like making an unwise acquisition or expanding too rapidly — and some investors feel they’re a good sign overall,” Capital Asset Management President and CEO John E. Girouard wrote in an article for Forbes. “For example, many investors’ first instinct on buybacks is, ‘Oh, this company must know something good is about to happen, and thus they want more profit for themselves.’”
Alongside the idea that good things are to come is the share price boost that buybacks can provide. If a company feels its shares are undervalued, it may buy them back and then resell them in the open market after it sees a share price improvement. This type of improvement is generally the result of simple supply and demand.
The possible positive impact of share buybacks
In September 2018, major miner Rio Tinto (ASX:RIO,LSE:RIO,NYSE:RIO) revealed its plans for a US$3.2 billion buyback program. The funds stemmed from post-tax coal disposal proceeds, with the company making the program a combination of an off-market buyback tender of Rio Limited shares (worth US$1.9 billion) and on-market purchases of Rio PLC shares.
“Returning US$3.2 billion of coal disposal proceeds demonstrates our commitment to capital discipline and providing sector leading shareholder returns,” said Jean-Sebastien Jacques, Rio Tinto chief executive.
“We continue to focus our portfolio on those assets which provide the highest returns and growth, which will ensure that we continue to deliver superior value to our shareholders in the short, medium and long term,” he continued.
Share buyback programs increase earnings per share, which makes a company more appealing to new investors and adds value for current shareholders. In the case of Rio Tinto, its well-rounded financial status made this particular buyback program a win-win for all involved.
“Because their balance sheet is in such a pristine state, every time they do an asset sale they’re normally just returning proceeds back to shareholders,” Jason Teh, chief investment officer of Vertium Asset Management, told Reuters.
The takeaway for investors
When a company institutes a buyback program, shareholders in the company should always ask themselves why it is occurring. Is the company changing direction? Does it need to increase its earnings per share? Is a buyback a way to regain equity, and therefore control?
It’s important to consider these questions, as the answers can determine whether it is prudent to hold on to a stock, or whether it’s better to take the buyback that is being offered. Share buybacks can also give insight into how a company is functioning overall, which is important when making investment decisions in general and can help when getting a feel for a company’s industry and field.
In any case, investors should carefully weigh all options and driving factors in order to make the best decision when a buyback is offered.
This is an updated version of an article first published by the Investing News Network in 2014.
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Securities Disclosure: I, Olivia Da Silva, hold no direct investment interest in any company mentioned in this article.