Share repurchase
Encyclopedia
Stock repurchase 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 shareholder
s 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 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.
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.
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 forced to retroactively disclose their repurchase activity. 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. Therefore, safeguards should be in place to ensure that increasing earnings per share in this way will not affect executive or managerial rewards, even though this does not always occur. Furthermore, 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.
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.
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.
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.
Company
A company is a form of business organization. It is an association or collection of individual real persons and/or other companies, who each provide some form of capital. This group has a common purpose or focus and an aim of gaining profits. This collection, group or association of persons can be...
of its own stock. In some countries, including the U.S.
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
and the UK
United Kingdom
The United Kingdom of Great Britain and Northern IrelandIn the United Kingdom and Dependencies, other languages have been officially recognised as legitimate autochthonous languages under the European Charter for Regional or Minority Languages...
, a corporation
Corporation
A corporation is created under the laws of a state as a separate legal entity that has privileges and liabilities that are distinct from those of its members. There are many different forms of corporations, most of which are used to conduct business. Early corporations were established by charter...
can repurchase its own stock
Stock
The capital stock of a business entity represents the original capital paid into or invested in the business by its founders. It serves as a security for the creditors of a business since it cannot be withdrawn to the detriment of the creditors...
by distributing cash
Cash
In common language cash refers to money in the physical form of currency, such as banknotes and coins.In bookkeeping and finance, cash refers to current assets comprising currency or currency equivalents that can be accessed immediately or near-immediately...
to existing shareholder
Shareholder
A shareholder or stockholder is an individual or institution that legally owns one or more shares of stock in a public or private corporation. Shareholders own the stock, but not the corporation itself ....
s in exchange for a fraction
Proportional (fair division)
Proportional division or simple fair division is the original and simplest problem in fair division. Fair division problems are also called cake-cutting problems. A proportional division of a cake between N people would ensure each of them got at least 1/N of the cake by their own valuation...
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
Treasury stock
A treasury stock or reacquired stock is stock which is bought back by the issuing company, reducing the amount of outstanding stock on the open market ....
, available for re-issuance.
Under U.S. corporate law
Corporations law
Companies law is the field of law concerning companies and other business organizations. This includes corporations, partnerships and other associations which usually carry on some form of economic or charitable activity. The most prominent kind of company, usually referred to as a "corporation",...
there are five primary methods of stock repurchase: open market, private negotiations, repurchase 'put
Put option
A put or put option is a contract between two parties to exchange an asset, the underlying, at a specified price, the strike, by a predetermined date, the expiry or maturity...
' rights, and two variants of self-tender repurchase: a fixed price tender offer
Tender offer
Tender offer is a corporate finance term denoting a type of takeover bid. The tender offer is a public, open offer or invitation by a prospective acquirer to all stockholders of a publicly traded corporation to tender their stock for sale at a specified price during a specified time, subject to...
and a Dutch auction
Dutch auction
A Dutch auction is a type of auction where the auctioneer begins with a high asking price which is lowered until some participant is willing to accept the auctioneer's price, or a predetermined reserve price is reached. The winning participant pays the last announced price...
. In the late 20th and early 21st centuries, there was a sharp rise in the volume of share repurchases in the United States: $
Dollar
The dollar is the name of the official currency of many countries, including Australia, Belize, Canada, Ecuador, El Salvador, Hong Kong, New Zealand, Singapore, Taiwan, and the United States.-Etymology:...
5 billion
1000000000 (number)
1,000,000,000 is the natural number following 999,999,999 and preceding 1,000,000,001.In scientific notation, it is written as 109....
in 1980 rose to $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 safeharbours against insider trading liability.
Purpose
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 forced to retroactively disclose their repurchase activity. 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
United States
The United States of America is a federal constitutional republic comprising fifty states and a federal district...
firms is provided by Alok Bhargava
Alok Bhargava
Alok Bhargava is an Indian econometrician. He studied mathematics at Delhi University and economics and econometrics at the London School of Economics. He is currently a full professor of economics at the University of Houston....
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
Executive compensation
Executive pay is financial compensation received by an officer of a firm, often as a mixture of salary, bonuses, shares of and/or call options on the company stock, etc. Over the past three decades, executive pay has risen dramatically beyond the rising levels of an average worker's wage...
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. Therefore, safeguards should be in place to ensure that increasing earnings per share in this way will not affect executive or managerial rewards, even though this does not always occur. Furthermore, 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.
Open-market
The most common share repurchase method in the United States is the open-market stock repurchase, representing almost 95% of all repurchases. A firm may or may not announce that it will repurchase some shares in the open marketOpen market
The term open market is used generally to refer to a situation close to free trade and in a more specific technical sense to interbank trade in securities.-Use of the term in economic theory:...
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.
Fixed price tender
Prior to 1981, all tender offer repurchases were executed using a fixed priceFixed price
The term "fixed price" is a phrase used in the English language to mean that no bargaining is allowed over the price of a good or, less commonly, a service...
tender offer. This offer
Offer and acceptance
Offer and acceptance analysis is a traditional approach in contract law used to determine whether an agreement exists between two parties. Agreement consists of an offer by an indication of one person to another of the offeror's willingness to enter into a contract on certain terms without...
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
Tender offer
Tender offer is a corporate finance term denoting a type of takeover bid. The tender offer is a public, open offer or invitation by a prospective acquirer to all stockholders of a publicly traded corporation to tender their stock for sale at a specified price during a specified time, subject to...
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
Price
-Definition:In ordinary usage, price is the quantity of payment or compensation given by one party to another in return for goods or services.In modern economies, prices are generally expressed in units of some form of currency...
. 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.
Dutch auction
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 curveSupply and demand
Supply and demand is an economic model of price determination in a market. It concludes that in a competitive market, the unit price for a particular good will vary until it settles at a point where the quantity demanded by consumers will equal the quantity supplied by producers , resulting in an...
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
Investment
Investment has different meanings in finance and economics. Finance investment is putting money into something with the expectation of gain, that upon thorough analysis, has a high degree of security for the principal amount, as well as security of return, within an expected period of time...
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.