What Is: A Share Buyback

As investing jargon goes, a share buyback is one of the simplest terms. It’s simply a company buying back its own shares. It can do this in one of two ways.

The first, and by far the most common, is when a company buys shares on the open market, just as a private investor does when they buy shares through a broker. A company has to get authority from its shareholders in order to buy back its shares. Usually this is done at its annual meeting. In the other method, though far less common, a company can announce a tender offer. This involves all shareholders submitting a price they would be prepared to accept for their shares.

In both instances once the company buys back the shares it will cancel them, so they will cease to exist. Therefore a company cannot put the same shares back onto the market at a later date.

Why do companies buy back their shares?
A company exists to allocate its resources in the most efficient manner for the benefit of its shareholders. Part of its resources may be surplus cash. Surplus cash is cash that it does not require to maintain or expand its business.

A company may decide to return this cash to its investors. This can be done either by a dividend or by buying back its shares. The decision as to which method is used usually depends on complex taxation issues that we can happily leave to the company’s accountants.

Companies can often be pressured by investment institutions to return their surplus cash rather than sitting on it and collecting low yields. The institutions argue that it should be their decision, and not the company’s, to hold part of their assets in cash.

How does it affect shareholders?
Share buybacks can be very good for shareholders. The laws of supply and demand suggests that with fewer shares on the market, the share price would tend to rise. Although the company will see a fall in profits because it will no longer receive interest on the cash, this is more than made up for by the reduction in the number of shares. In effect you get more pie — though the total size of the pie is slightly reduced, this is more than offset by the fact that you get a bigger slice.

And when the company is purchasing shares that are undervalued — the ideal time to execute a buyback — the benefit to you is enhanced because the company funds are being used to buy a Euro for €0.75… or less!

But beware…
Not every share buyback is a reason to cheer though. Because company executives know that investors tend to like share buybacks, they may announce big buyback programs to win shareholder goodwill, not practice good capital allocation.

Further, some management teams simply don’t pay enough mind to the valuation of the company’s shares when planning a buyback. They simply see a buyback as a route to return capital to shareholders, rather than an investment in the company’s own equity.

When a company executes a share buyback when shares are richly priced, this has the opposite effect that we’d want to see. They may be spending €1.2 — or more! — to buy one Euro worth of value. Over time, that can seriously hurt your investment returns from that company.

As a Foolish investor, you’re careful with what you’re investing in and when you’re investing in it. You understand the business that you’re buying and you have a good sense of what that business is worth. That guides you towards buying when the price is right and sitting on the sidelines when the price/value tradeoff isn’t as attractive. You should demand the same from the management teams running the companies you own.

And remember, it’s not like there aren’t other options. When a company’s market value is such that a buyback doesn’t make sense, a management team that wants to return cash to shareholders can always do it through a good, old-fashioned dividend.