A share repurchase is the action of a company buying back its own shares on the open stock market. This corporate event is also known as a share buyback. A company may have a number or reasons for initiating a buyback but as signaling theory suggests, one reason maybe that management considers its own stock to be undervalued. In addition to buying stock directly from the stock market, the company via a tender or Dutch tender process, can offer to buy its own stock directly from the existing shareholders all at the same price. The completion of this repurchase reduces the number of outstanding shares, which may (at least temporarily) increase the price.
A share repurchase program is the opposite of dilution. Companies initiate share repurchase programs to undue the effects of dilution when there is surplus cash or to take advantage of low interest rates and reorganize the firm’s capital structure. Following the abandonment of the HP merger by Xerox, HP has stated it will continue with its buyback program. Suggesting a repurchase is a favorite tactic of activists.
The Pro's and Con's of a Share Repurchase Programs
Benefits of a Buyback
During a hostile takeover approach, a target firm may use a repurchase program as a defense tactic. Management may claim the firm believes its shares are undervalued and rather than be the victim of an opportunistic acquirer it convinces the market that funds are available to purchase its own stock. Accordingly, signaling theory would suggest to investors that the business has sufficient cash set aside for economic emergencies. Whether or not this is an efficient method of using the firm’s capital will only be discernible far into the future. In the short term, the share repurchase reduces the number of existing shares. This causes the EPS to increase while simultaneously lowering the PE ratio. However, this is an accounting calculation and the underlying profitability of the company has not changed.
Drawbacks of a Buyback
Despite the above, a major and consistent criticism of buybacks is timing. It is possible that managers may be in a better position to judge to long-term value of its own stock but this has rarely been proven in the real world. In the event of a takeover defense, the act is more reactionary than proactive.
Alternatively, an activist shareholder may encourage a company to return more cash to shareholders. Again, the long term effect of this plan will only be felt long after those shareholders have moved on to their next target. Ironically, management may have no other use for excess cash, even after the rainy day fund is topped up. In this instance, a buyback may be ideal. However, this signals to investors there are no opportunities for investment in the firm. This may cause investors to shun the company and the stock will decline.
