Investing Fundamentals: Share Buybacks [Part 4]

What are share buybacks and what are the benefits?

Share buybacks are a popular way for companies to return capital to shareholders and increasingly so in the past year, where we have seen share prices come under pressure and management repurchasing shares where they believe the company is undervalued. Naspers and Prosus are two prime examples of buybacks taking place in the market.

Naspers and Prosus recently announced a share buyback programme on 27 June 2022. The market responded positively to the announcement and the share price shot up nearly 23% on the day. But what exactly is a share buyback and why would a company want to repurchase their own shares?

What is a share buyback?

A share buyback is exactly what it sounds like. It is when a company repurchases its own shares back from existing shareholders. Management typically will choose to buy back shares when they believe that the shares are trading at a price below what they believe the intrinsic value of the shares to be.

What impact does a share buyback have for a shareholder?

A share buyback will reduce the number of shares in issue of the company. When a company decides to buy back their own shares, they will make an offer to purchase the shares from existing shareholders, usually at the current market price. As a shareholder you have one of two options. Firstly, you could decide to sell a portion, or all your shares back to the company and take the money. Secondly you could elect not to sell any of your shares. If you elect not to sell any of your shares, your percentage ownership in the company will increase after the buyback. Let me explain this through a basic example.

Assume you own shares in Company X which has a market capitalisation of R1 million. Assume the company currently has 10 000 shares in issue, and you own 1 000 shares. This means that each share is worth R100 (R1 000 000 / R10 000) and that you own 10% of the company (your 1 000 shares / total 10 000 shares in issue). This means that your investment in Company X is worth R100 000 (R1 million x 10%). If Company X decided to repurchase 2 000 shares back from existing shareholders and you decided not to sell any of your shares, how would that affect your investment?

Instead of owning 10% of the company you would now own 12.5%. How did I get to this figure? Initially our 10% ownership was calculated by taking the number of shares you own (1 000 shares) and dividing by the number of number of shares outstanding (10 000 shares). However, after the buyback the number of shares in issue have decreased from 10 000 to 8 000 as a result of the company electing to repurchase 2 000 shares.

Our percentage ownership would now be calculated as our 1 000 shares owned divided by the new total shares in issue of 8 000 giving us 12.5% effective ownership. So, what is our investment worth now? Assuming the value of the company has remained at R1 million, our investment would be worth R125 000 (R1 million x 12.5% effective ownership) at this point. The key take-away from this should be that, as a shareholder, if you elect to not sell any of your shares during a buyback your percentage shareholding in the company will increase after the share buyback. A share buyback will increase your ownership in a company, whereas a company issuing new shares (rights issue) would dilute your shareholding in a company.

Why would a company decide to buy back its shares?

There are many reasons why companies may decide to repurchase their own shares. Some of the main reasons are:

1. Increase in EPS: The earnings per share (EPS) of a company is a measure of profitability. EPS is calculated by taking the net profit (earnings) of a company and dividing by the number of shares in issue. Investors typically look for a growing EPS. Management can increase the EPS of a company by repurchasing shares. Thus, even if earnings do not increase, by decreasing the denominator (number of shares in issue) the earnings per share will increase. If this is confusing, imagine the earnings of a company representing a pizza and the number of shares representing the slice of a pizza. If you decide to divide your pizza into 4 slices instead of 6 slices the size of each slice with, be bigger. In this comparison, the size of the slice of pizza is your earnings per share. So, management could make the slices of pizza bigger in one of two ways. They could either make the entire pizza bigger (growing earnings) or they could just cut the pizza into fewer slicers (reducing the number of shares in issue).
2. Signalling Effect: A share repurchase generally signals to the market that the companys management believes that the price of the stock is undervalued. A company that repurchases shares when they believe the share price to be undervalued could then reissue these shares at a later stage when the share price has increased and is in line with the intrinsic value of the stock.
3. Flexibility: A company may elect to repurchase shares instead of issuing dividends to improve shareholder value. Repurchasing shares offers more flexibility to a company than issuing dividends as the repurchase can be spread over a longer period. A company may wait for dips in the share price to repurchase shares at opportune times.
4. Use for Excess Liquidity: If a company has a large cash pile on the balance sheet that is currently earning very low interest returns, they may decide to use some of this excess liquidity to repurchase shares in the company.