Some stock market investors may be wondering why a company with healthy business operations that possesses excess cash is not allocating its wealth to its shareholders through cash dividends. Repurchasing stocks is an alternative for distributing dividends but has a deeper purpose as to the motive it has to be implemented. Share repurchases (also known as share buybacks) occur when the management team of a public corporation acquires additional shares of outstanding stock that formerly traded to the open market.
Before conducting any trading activities, it is important for investors to read a wide variety of broker reviews prior to opening live accounts. There are two ways to buy back shares: the corporation can purchase the shares marketed in the public or from its shareholders when they are provided the option. As a result of the buyback, this transaction will decrease the number of shares outstanding. The shares will not be allowed to be sold to the public and recorded as treasury stock in the financial statements. However, the holders of repurchased stocks will not become eligible for voting rights
Rationale for Stock Repurchases
Repurchases show that shareholders are being offered an affirmative outcome. Therefore, there is a growing number of companies that are considering spending their cash in buying back their stocks. Here are the reasons why the reacquisition of stocks occurs:
The market is keeping its eyes on certain financial ratios. As buybacks take place, the number of outstanding shares drops and will affect financial ratios such as Earnings per Share (EPS), Return on Assets (ROA), and Return on Equity (ROE).
The enhancement of financial ratios is often a spinoff since this is not the only purpose of announcing a share buyback.
Optimism Towards its Undervalued Share Price
It can indicate that the company has excess cash that instead of distributing it to the shareholders through dividends, the cash is spent in repurchasing its own stocks. In addition, stock buyback might denote confidence of the management thinking that the company has a healthy performance. The management may have high hopes for the company despite its undervalued share price due to the acquisition of a company, a launch of a new business line, or other reasons that may appreciate its stock price. This transaction might encourage potential investors to buy since the company is buying its own shares.
Minimizing the Effect of Dilution
During the 1990s, the employee stock option was popularized because it was exercised by the companies in order to compensate its employees without disbursing its cash. The application of the employee stock option has extremely affected the existing shareholders as it diluted its portion of the ownership of the company. With the intention of controlling the dilution, companies started to buy their shares back and can maintain their percentage over the ownership.
New shares are released by companies to the market in order to raise capital. As the issuance of new shares continues, the prevailing shareholders will own a smaller percentage of the company. Repurchasing stocks is one of many ways to aid this problem of the shareholders. Through this transaction, the ownership of the shareholders will rise since the number of shares outstanding has decreased. Aside from buybacks, another way to prevent dilution from occurring is by offering the new shares first to the existing shareholders in proportion to their present percentage. Once the existing shareholders buy the share in its entirety, their ownership will not be diluted.
Beneficial Plans to Spend Cash
Aside from distributing cash dividends, stock repurchasing is also a good way to repay its shareholders and a practical means to consume its excess cash flow. But it can also mean that the company is unable to think of good ideas to use its cash such as expanding its business operations or venturing to a new product line. The management only thinks that the company has provided everything to enhance its performance but is still deemed by the market as low-priced.
How Do Stock Repurchases Are Done?
As soon as companies have decided to buy their own shares, they will be obliged to execute their responsibility of disclosing the reasons behind the repurchase and the information about the method that will be implemented to reacquire stocks. There are four methods in repurchasing stocks.
Effects of Stock Repurchases
Investors must also be aware that repurchasing shares increases the company’s ROA, ROE, and EPS without requiring them to escalate profitability and will only cut costs by decreasing the denominators of these ratios. With the aim of the shares to be attractive for the sellers, the tender price is adjusted beyond the current price.
In conclusion, the opinion of the management that each company is undervalued is convincing especially if the top managers repurchased its shares. Although this decision will have a positive short-term impact on the stock price, a highly-developed plan to boost the business performance will still provide a greater edge to put an ascending pressure on the share price.