Companies have at their disposal two main options when they want to return cash to shareholders.
Dividends tend to be preferred by income investors; a dividend is a cash payout to shareholders, typically issued on a half-yearly basis.
The other method is to use a share buyback. This means just what it says – the company buys back its own shares.
It’s easy to see why shareholders like dividend payouts. But how do buybacks benefit shareholders? Well, when a company buys and cancels some of its own shares, the remaining shareholders are left holding a greater proportion of the company.
Let’s say a firm has one million shares in issue, and the share price is $10 per share. It made one million dollars profit last year. So it has earnings per share of $1.
Let’s say it wants to return the whole one million dollars profit to its shareholders via a share buyback. It buys back 100,000 shares at $10 a share and cancels them. This leaves 900,000 shares in issue.
That means earnings per share has increased from $1 to just over $1.11, because there are now fewer shares. In turn, assuming that investors keep valuing its earnings on a constant basis, the share price would rise to just over $11.
Fans of buybacks argue that they are more tax-efficient than dividends. For managers, buybacks are also more flexible than dividend payments. Shareholders tend to react more negatively to a dividend cut than to a reduction in buyback levels.
Critics argue that executives have an incentive to use buybacks to meet performance targets linked to share-price growth. So they may curb investment or borrow too much to fund buybacks.
Timing can also be a problem. Some studies suggest that larger companies in particular have a bad habit of buying back shares near the top of the market, when they’re expensive, rather than nearer the bottom, when they’re cheap.
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