Shareholders’ Equity: Share Buy Backs
Share buyback is the process by which the company reacquires part of the shares it had previously issued. The process basically entails exchanging money for a part of the company’s equity held by the existing shareholders. During the process, the number of stock held by the public is reduced and is gained by the company as part of its position in the Company’s equity. The repurchased stocks are either kept in the treasury ready for reissue when the company next wishes or they are completely retired from trading in the market. Stock repurchase can be done in the open market where the company announces that it will be buying back part of its equity from the share holders. In the open market option, the company repossesses shares at the market price. It can also be conducted through tender offer where the company specifies the amount of shares it wishes to repurchase and the repurchase price.
The objective of this research is to discuss the concept of share buyback in a wider spectrum. The research discusses the motives behind share buy back, when the process works or fail, the merits and demerits, and finally the accounting procedures for bought back shares.
Motives behind Share Buyback
There are many reasons that drive a company to buy back its shares from the investors but they are never disclosed to the investors. Firstly, buybacks aim at increasing earnings per share in a market where the company’s performance is appraised on earnings per share. Reducing the number of outstanding share count increases earnings per share because earnings will be distributed amongst less number of shares (Stevenman, 2010, 1). The other motive is to take advantage of lower price of shares which results from market undervaluation. Buybacks also are done in order to attain a capital structure that is relatively more efficient. In this case, share buybacks alters the debt to equity ratio especially for debt issue financed equity which in turn improves the efficiency of capital structure. The other motive is to return capital after a company sells a portion of its business. For instance, the sale of Prometric by Sylvian Learning System (SLS) was followed by the launch of share self tender for SLS shares (Opler & Ikenberry 1).
Cases Where Buyback are likely to succeed
In case the company repurchases shares without any plan of selling them in the market again, the buyback is likely to succeed. This is beneficial to the shareholders because they repossess a bigger part of the company. As a result, the company will have a big share of the earnings because relatively less of it will be distributed as dividends. The process will also work where it acts as an alternative for investing cash in a new product. Investing cash in a new product can be very risky for the company especially if the investment does not pay off returns but repurchasing shares is less risky. The most risky investment can be paying for acquisition using cash. This is because in most cases mergers and acquisition do not live up to expectations and may cause huge losses. When a company repurchases its shares, it invests in its own stocks where it has confidence that the shares are undervalued and will pay returns to the shareholders in future. Share repurchase will also work where the process offers better return than using cash to venture into new markets. This is almost guaranteed because the repossessed shares are mostly undervalued at the point of repurchase. The shares are therefore likely to offer better returns in future than cash invested in new operations.
Cases where share buyback may fail to work
Share repurchase may not work where the motive for doing repurchase is not economically viable. Share buybacks will fail if done in the following circumstances:
Overvalued shares: A company buying back shares need to be sure that the shares are not overvalued but undervalued. Like any other normal investor, the company may not have full information about valuation of shares already trading in the market. There is therefore high risk of buying overvalued shares (McClure, 2010, 1). This will be a poor investment decision and will destroy the shareholders value instead of earning them more returns. The company would rather distribute that cash as dividends.
Boosting earnings per share: buying back shares means the company decreases the shares in the market thus leaving a few shares on which earnings are distributed. This will increase earnings per share. This is misleading to investors who will expect share value to increase as a result of increased earnings per share (Opler & Ikenberry, 2010, 1). This will not work because the company spent cash to buyback the shares and they will adjust valuations in order to account for the cash spent. The cash earnings will be lower than the expectations of the investors. Lower cash earnings will be distributed among fewer share count and no significant effect on share value.
Financing buyback using debt: the assumption of the shareholders in this case is that the cash flow due to pay the debt will keep on growing which may not be the case always. If the assumption fails, the investors will suffer (McClure, 2010, 1). The other assumption is that shares are undervalued. If shares were overvalued, borrowing to finance buyback drains cash reserve which may not be recovered if shares give no return.
Merits and demerits of share buyback
Ceteris paribus, share buyback increases earnings per share because it reduces the number of shares in the market. The other advantage is that share buyback reduces the supply of share in the market thus increasing share price. In recessionary periods, share buyback offers a price support to the investors as they get a chance to sell their shares (Smith, 2009, 1).
Share buyback also has disadvantages. For instance, it can be deceiving to the market observers and the investors because they hide unfavorable financial ratios making the company’s position to appear strong even when it is not so.
Current Trends in Share Buybacks and their accounting procedures
According to Stevenman (2010, 1), stock buybacks have been increasing at a high rate especially the third quarter of 2009. The total buy backs for standard& poor 500 index amounted to $34.8 billion as per the third quarter records. This was 43.8% increase compared to the second quarter the same year 2009. The trend is expected to grow in the coming years. According to Werksmans Attorneys (2004, 1), share buyback is addressed under section 85 of the companies Act. Paragraph 4 of section 85 spares companies any form of payment or tax on share buyback, provided it is done on genuine grounds. The amount of gain on the initial price of shares is recognized and is not taxed. In the same way, the associated losses are not tax deductible. The acquired shares are recognized as part of authorized shares of the company.
Share buybacks could be accounted for using cost or par value method. Under the cost method, when shares are repurchased, the paid-up-capital is debited in order to deduct the bought back shares (Vermaelen, 2005, 13). Incase the shares are sold again; we debit the paid up capital account if they are sold at a premium and vice versa. In the par value method, the bought back shares are debited in the common stock account and increase treasury stock as retired shares. If the shares are resold, the cost method of accounting is applied as above.
Share buybacks have increased greatly over the past couple of years and seems to continue growing in the years to come. The process is not legalized in some countries but it is very common in US and the United States. Share buyback can be very beneficial to the company if it is done the right manner.
McClure, B (2010). 6 Bad Stock Buyback Scenarios. London: McClure & Co. Web.
Opler, T. & Ikenberry, D. (2010). Share Buybacks: bridge to shareholder Value; Investor relations strategy of share buyback programs. London: High beam research. Web.
Smith A. (2009). Stock buybacks, the pros and cons examined. New York: Reink Media Group LLC. Web.
Stevenman, B (2010). Stock buy backs offer shareholders mixed Blessings. New York: Bloomberg business week. Web.
Vermaelen, T (2005). Share repurchases. New York: Now Publishers Inc. Print.
Werksmans, A. (2004). Some tax problems with Treasury Shares. S.A. Integritax Newsletter. Web.