||The examples and perspective in this article deal primarily with the United States and do not represent a worldwide view of the subject. (December 2010)|
Stock repurchase (or share buyback) is the reacquisition by a company of its own stock. In some countries, including the US 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. The company either retires the repurchased shares or keeps them as treasury stock, available for re-issuance.
Under US 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 US: US$5 billion in 1980 rose to US$349 billion in 2005.
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 safe-harbours against insider trading liability.
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, 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. 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. 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.
Financial markets are unable to accurately gauge the meaning of repurchase announcements, because companies will often announce repurchases and then fail to complete them. Repurchase completion rates increased after companies were required to retroactively disclose their repurchase activity, the result of an effort to reduce the perceived or potential exploitation of public investors. Normally, investors have more of an adverse reaction to dividend cuts 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, they may repurchase the currently undervalued shares, wait for the market to correct the undervaluation whereby prices increase to the intrinsic value of the equity, and re issue them at a profit. Alternatively, they 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 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 (2013) reports that stock options exercised by top executives increase future share repurchases by US 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 increases in shareholder 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 share repurchases bolster the stock price, making a takeover more expensive.
Tax-efficient distribution of earnings
Share repurchases also allow companies to covertly distribute their earnings to investors without inflicting them with taxation. For example, if a company were to pay US$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 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 accordingly, from US$10 to US$9.90, so the investor with 10 shares now has; US$99 + 85¢ dividend, or US$99.85. Of course, the market will not necessarily respond to a dividend payment by selling off shares and reducing share price; while the payment of the dividend technically reduces the company's book value, the ability and willingness to pay a dividend is often seen positively, and the share price may even increase.
Compare this with spending US$100,000 buying back shares. This will remove 10,000 shares from the market, leaving 990,000 shares at $10 each ((US$10,000,000 − US$100,000)/990,000 = US$10). Now, the investor with 10 shares still has US$100, and the government receives no immediate tax revenue. Ultimately, there should be no net change in investor wealth assuming a fully equity financed business. This disparity assumes there is no capital gains tax for the selling share holders.
The most common share repurchase method in the US 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.
Fixed price tender
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. 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. 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 favor 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. 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.
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Bhargava, Alok (2010). "An econometric analysis of dividends and share repurchases by US firms". Journal of the Royal Statistical Society A, 173, 631-656.
Bhargava, Alok (2013). "Executive compensation, share repurchases and investment expenditures: Econometric evidence from US firms". Review of Quantitative Finance and Accounting, 40, 403-422.
- Michael Simkovic, "The Effect of Enhanced Disclosure on Open Market Stock Repurchases", 6 Berkeley Bus. L.J. 96 (2009).
- Amedeo De Cesari, Susanne Espenlaub, Arif Khurshed and Michael Simkovic, "The Effects of Ownership and Stock Liquidity on the Timing of Repurchase Transactions", 2010
- For evidence of the increased use of share repurchases, see Bagwell, Laurie Simon and John Shoven, "Cash Distributions to Shareholders" 1989, Journal of Economic Perspectives, Vol. 3 No. 3, Summer, 129-140.
- Investopedia, Float, online available: http://www.investopedia.com/terms/f/float.asp (last accessed November 20, 2009).
- Bagwell, Laurie Simon, "Dutch Auction Repurchases: An Analysis of Shareholder Heterogeneity" 1992, Journal of Finance, Vol. 47, No. 1, page 73.
- To understand the Dutch auction bidding and outcome from actual shareholder tendering responses, see Bagwell, Laurie Simon, "Dutch Auction Repurchases: An Analysis of Shareholder Heterogeneity" 1992, Journal of Finance, Vol. 47, No. 1, 71-105.
- The 10/12 limit refers to ASIC's requirement that companies buy back no more than 10% of the voting rights in the company within 12 months - Share Buy-backs