Stock repurchase (or share buyback) is the reacquisition by a company of its own stock. In some countries, including the U.S. and the UK, a corporation can repurchase its own stock by distributing cash to existing shareholders in exchange for a fraction of the company's outstanding equity; that is, cash is exchanged for a reduction in the number of shares outstanding.[1][2] The company either retires the repurchased shares or keeps them as treasury stock, available for re-issuance.
Under U.S. corporate law there are five primary methods of stock repurchase: open market, private negotiations, repurchase 'put' rights, and two variants of self-tender repurchase: a fixed price tender offer and a Dutch auction. In the late 20th and early 21st centuries, there was a sharp rise in the volume of share repurchases in the United States: $5 billion in 1980 rose to $349 billion in 2005.[3]
It is relatively easy for insiders to capture insider-trading like gains through the use of "open market repurchases." Such transactions are legal and generally encouraged by regulators through safeharbours against insider trading liability.[1][2]
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Companies making profits typically have two uses for those profits. Firstly, some part of profits can be distributed to shareholders in the form of dividends or stock repurchases. The remainder, termed stockholder's equity, are kept inside the company and used for investing in the future of the company. If companies can reinvest most of their retained earnings profitably, then they may do so. However, sometimes companies may find that some or all of their retained earnings cannot be reinvested to produce acceptable returns.
Share repurchases are an alternative to dividends. When a company repurchases its own shares, it reduces the number of shares held by the public. The reduction of the float,[4] or publicly traded shares, means that even if profits remain the same, the earnings per share increase. Repurchasing shares when a company's share price is undervalued benefits non-selling shareholders (frequently insiders) and extracts value from shareholders who sell. There is strong evidence that companies are able to profitably repurchase shares when the company is widely held by retail investors who are unsophisticated and more likely to sell their shares to the company when those shares are undervalued.[2] By contrast, when the company is held primarily by insiders and institutional investors, who are more sophisticated, it is harder for companies to profitably repurchase shares.[2] Companies can also more readily repurchase shares at a profit when the stock is liquidly traded and the companies' activity is less likely to move the share price.[2]
Financial markets are unable to accurately gauge the meaning of repurchase announcements, because companies will often announce repurchases and then fail to complete them.[1] Repurchase completion rates increased after companies were forced to retroactively disclose their repurchase activity.[1] Normally, investors have more adverse reaction in dividend cut than postponing or even abandoning the share buyback program. So, rather than pay out larger dividends during periods of excess profitability then having to reduce them during leaner times, companies prefer to pay out a conservative portion of their earnings, perhaps half, with the aim of maintaining an acceptable level of dividend cover. Some evidence of this phenomenon for United States firms is provided by Alok Bhargava who found that higher dividend payments lower share repurchases though the converse is not true (Bhargava, 2010).
Aside from paying out free cash flow, repurchases may also be used to signal and/or take advantage of undervaluation. If a firm's manager believes their firm's stock is currently trading below its intrinsic value they may consider repurchases. An open market repurchase, whereby no premium is paid on top of current market price, offers a potentially profitable investment for the manager. That is, he may repurchase the currently undervalued shares, wait for the market to correct the undervaluation whereby prices increases to the intrinsic value of the equity, and re issue them at a profit. Alternatively, he may undertake a fixed price tender offer, whereby a premium is often offered over current market price, sending a strong signal to the market that he believes the firms equity is undervalued, proven by the fact that he is willing to pay above market price to repurchase the shares.
Another reason why executives, in particular, may prefer share buybacks is that executive compensation is often tied to executives' ability to meet earnings per share targets. In companies where there are few opportunities for organic growth, share repurchases may represent one of the few ways of improving earnings per share in order to meet targets. Thus, safeguards should be in place to ensure that increasing earnings per share in this way will not affect executive or managerial rewards. For example, Bhargava (2011) reports that stock options exercised by top executives increase future share repurchases by U.S. firms. Higher share repurchases, in turn, significantly lowered the Research and Development expenditures that are important for raising productivity. Further, increasing earnings per share does not equate to increase in shareholders value. This investment ratio is influenced by accounting policy choices and fails to take into account the cost of capital and future cash flows, which are the determinants of shareholder value.
Share repurchases avoid the accumulation of excessive amounts of cash in the corporation. Companies with strong cash generation and limited needs for capital spending will accumulate cash on the balance sheet, which makes the company a more attractive target for takeover, since the cash can be used to pay down the debt incurred to carry out the acquisition. Anti-takeover strategies therefore often include maintaining a lean cash position, and at the same time the share repurchases bolster the stock price, making a takeover more expensive.
Share repurchases also allow companies to covertly distribute their earnings to investors without inflicting them with double taxation. This only holds true in jurisdictions which do not operate imputation tax credit systems. For example, if a company were to pay $100,000 in dividends on one million shares or as 10¢ dividend per share, investors may incur tax upon this disbursement. This means that instead of receiving 10¢ of already taxed earnings per share, they receive 8.5¢ (.10×(1 − .15)) at a 15% tax rate with 1.5¢ going to the government. An investor with 10 shares will receive 85¢. As the company has to pay out this money the share price drops according, from $10 to $9.90, so the investor with 10 shares now has; $99 + 85¢ dividend, or $99.85.
Compare this with spending $100,000 buying back shares. This will remove 10,000 shares from the market, leaving 990,000 shares at $10 each (10,000,000 − 100,000 = 9900000/990000), meaning our investor with 10 shares still has $100, and the government receives no tax revenue. Ultimately there is no net change in investor wealth assuming a fully equity financed business. They also minimize transaction costs.
The most common share repurchase method in the United States is the open-market stock repurchase, representing almost 75% of all repurchases. A firm may or may not announce that it will repurchase some shares in the open market from time to time as market conditions dictate and maintains the option of deciding whether, when, and how much to repurchase. Open-market repurchases can span months or even years. There are, however, daily buy-back limits which restrict the amount of stock that can be bought over a particular time interval again ranging from months to even years.
Prior to 1981, all tender offer repurchases were executed using a fixed price tender offer. This offer specifies in advance a single purchase price, the number of shares sought, and the duration of the offer, with public disclosure required. The offer may be made conditional upon receiving tenders of a minimum number of shares, and it may permit withdrawal of tendered shares prior to the offer's expiration date. Shareholders decide whether or not to participate, and if so, the number of shares to tender to the firm at the specified price. Frequently, officers and directors are precluded from participating in the tender offer. If the number of shares tendered exceeds the number sought, then the company purchases less than all shares tendered at the purchase price on a pro rata basis to all who tendered at the purchase price. If the number of shares tendered is below the number sought, the company may choose to extend the offer’s expiration date.
The introduction of the Dutch auction share repurchase in 1981 allows an alternative form of tender offer. The first firm to utilize the Dutch auction was Todd Shipyards.[5] A Dutch auction offer specifies a price range within which the shares will ultimately be purchased. Shareholders are invited to tender their stock, if they desire, at any price within the stated range. The firm then compiles these responses, creating a demand curve for the stock.[6] The purchase price is the lowest price that allows the firm to buy the number of shares sought in the offer, and the firm pays that price to all investors who tendered at or below that price. If the number of shares tendered exceeds the number sought, then the company purchases less than all shares tendered at or below the purchase price on a pro rata basis to all who tendered at or below the purchase price. If too few shares are tendered, then the firm either cancels the offer (provided it had been made conditional on a minimum acceptance), or it buys back all tendered shares at the maximum price.
In broad terms, a selective buy-back is one in which identical offers are not made to every shareholder, for example, if offers are made to only some of the shareholders in the company. In the US, no special shareholder approval of a selective buy-back is required. In the UK, the scheme must first be approved by all shareholders, or by a special resolution (requiring a 75% majority) of the members in which no vote is cast by selling shareholders or their associates. Selling shareholders may not vote in favour of a special resolution to approve a selective buy-back. The notice to shareholders convening the meeting to vote on a selective buy-back must include a statement setting out all material information that is relevant to the proposal, although it is not necessary for the company to provide information already disclosed to the shareholders, if that would be unreasonable.
A company may also buy back shares held by or for employees or salaried directors of the company or a related company. This type of buy-back, referred to as an employee share scheme buy-back, requires an ordinary resolution. A listed company may also buy back its shares in on-market trading on the stock exchange, following the passing of an ordinary resolution if over the 10/12 limit.[7] The stock exchange’s rules apply to on-market buy-backs. A listed company may also buy unmarketable parcels of shares from shareholders (called a minimum holding buy-back). This does not require a resolution but the purchased shares must still be cancelled.
Bhargava, Alok (2010). "An econometric analysis of dividends and share repurchases by U.S. firms". Journal of the Royal Statistical Society A, 173, 631-656.
Bhargava, Alok (2011). "Executive compensation, share repurchases and investment expenditures: Econometric evidence from U.S. firms". Review of Quantitative Finance and Accounting.