The Bare Essentials of Share Buybacks

09/22/2010 1:18 pm EST

Focus: MARKETS

John Heinzl

Reporter and Columnist, GlobeInvestor.com

There has been a rush of companies using excess cash to purchase their shares. Why not bump up dividends or reinvest? Here’s a few reasons why, from John Heinzl, reporter and columnist for GlobeInvestor.com.

Share buybacks have been making headlines, with companies such as MasterCard (NYSE: MA), Texas Instruments (NYSE: TXN), and Hewlett-Packard (NYSE: HPQ) announcing plans to repurchase billions of dollars of their own shares.

What started as a trickle has turned into a raging river. According to Birinyi Associates, US companies have announced $258-billion (US) of buybacks this year, up from just $52-billion in the first three quarters of 2009.

The frantic pace of buybacks prompted a question—actually several questions—from a reader:

“In a share buyback the company cannot force me to sell my shares, can it? When it buys back shares it purchases any available shares out there, right? One other question: Why is it good for a company to buy back shares?” - J.F.

To answer your first question, when a company announces a buyback it can’t force you to sell your shares. The company purchases the shares in the open market, just as any investor would. It then cancels the shares, which reduces the number of shares outstanding.

Because there are fewer shares outstanding, the company’s earnings per share rise (all other things being equal). If you think of the company’s earnings as a pie, the size of the pie doesn’t change, but each investor’s piece gets bigger. So in that sense a buyback increases each shareholder’s claim on the profits.

What’s Driving the Buyback Boom?

A couple of factors are at play here. Companies are sitting on huge amounts of cash—see chart—and buying back shares is one way to return money to shareholders. Other options for excess cash include dividends, acquisitions, paying down debt, or reinvesting the cash in the business.

Another reason for the growing number of buybacks is that, with interest rates at rock-bottom levels, companies can issue debt cheaply and use the proceeds to repurchase their own equity.

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That’s not to say buybacks are always the best use of capital.

“If a company can reinvest the money into the business and get a great rate of return—that’s the kind of company we like—then we’d rather they do that. That’s a better investment for us,” said Larry Sarbit, Winnipeg-based manager of the $135-million IA Clarington Sarbit US Equity Fund.

“But if they’re generating a lot of cash and it’s piling up and they don’t have an acquisition or need the capital to reinvest in the business, then a buyback makes a lot of sense because it shrinks the outstanding shares and results in more ownership by the remaining shareholders.”

Some investors would rather have cash returned as a dividend, because they prefer to have the money in their pocket. But a buyback is not taxable—unless you sell your shares at a profit—whereas a dividend is (unless it’s in a registered account).

What’s more, from the company’s standpoint a buyback provides greater flexibility. The company is under no obligation to repurchase its shares after authorizing a buyback. Nor is it required to renew a buyback.

On the other hand, when a company pays a dividend, it is making an implicit promise to continue paying that dividend in subsequent quarters, and ideally to raise the dividend over time as profits grow.

When Buybacks Are a Bad Idea

“If you do buybacks in the right way, they’re going to be beneficial to shareholders. If you don’t do them in the right way, they’re not going to be beneficial,” said Pavel Begun, partner with 3G Capital Management in Toronto.

It all comes down to the price of the stock. If the stock is trading at a substantial discount to its “intrinsic” value, then repurchasing the shares is an effective use of capital and will add to shareholder value, he said. But if the stock is trading at a substantial premium to its intrinsic value, then buying back the company’s overpriced shares is not an effective use of capital.

What’s intrinsic value? Basically, it’s the present value of the company, based on assumptions about how much cash flow it will throw off in the future. The sum of these projected cash flows is discounted back to today using an interest rate known as the discount rate.

Evidently, many companies feel their shares are a good buy at current levels.

“Companies are finally feeling a little bit more comfortable and realizing that their own shares are cheap,” David Kelly, chief market strategist for JPMorgan Funds in New York, told Bloomberg.

That, combined with low interest rates and huge amounts of cash, suggests the buyback boom will continue.

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