Share Repurchase Theory/ Stock Buyback Theory (Critical Review)

By Jackie, Researcher

Topic: Education

Area of discussion: Finance

Chapter: Dividend policy

Subchapter: Alternatives to cash dividends - Share repurchases

The objectives of this research are to find out is there any effects on the stock price when a company purchases its own shares, what are the effects of stock buyback on certain financial ratios, and what are the reasons or motives for share repurchases. By the way, this topic is very popular as questions are often set out from this chapter in finance examination. Therefore, it is good to actually understand and gain some knowledge about the basic concept of share repurchases although we might not be playing shares in real-life.

Introduction

Share repurchase is a programme by which a company buybacks its own shares in the open market. Ideally, there are three general ways of doing it: tender offer (shareholders are invited to offer their shares to be sold back at the price set by the company), stock market purchase (repurchases of own stock in the open market at current market prices), and agency buy back/ arrangement (brokers are employed as agents to organize the repurchases of its shares from institutional shareholders).

Let’s look at this example: 

If INTI Corp Bhd uses RM15 million of its cash to repurchase its shares at RM5.00 per share, what is the new return on assets (ROA), earnings per share (EPS) and price per share?

Solution (Effects):

Cash = RM20 million – RM15 million = RM5 million

Total assets = RM50 million – RM15 million = RM35 million

Total number of shares repurchased = RM15million ÷ RM5 per share = 3 million shares

No of ordinary shares outstanding = 10million shares – 3million shares = 7million shares

New return on assets (ROA)

= (Earnings ÷ Total assets) x 100%

= (RM2 million ÷ RM35 million) x 100%

= 5.71%

New earnings per share (EPS)

= Earnings ÷ No of ordinary shares outstanding

= RM2 million ÷ 7 million shares

= RM0.29 per share

New price per share

= (Total assets – Cash spent on repurchasing) ÷ No of ordinary shares outstanding

= (RM50 million – RM15 million) ÷ 7 million shares

= RM5.00 per share

Critical explanation:

Is it 100% confirm that, ROA and EPS will rise when a company purchased its own shares?

Theoretically and practically, yes! This is because both ROA and EPS’s numerators (the number on the top of a fraction) i.e. earnings remain unchanged in stock repurchase. However, their denominators (the number on the bottom of a fraction) decrease where total assets decreased due to cash used in repurchasing (in ROA) and total number of ordinary shares declined due to stock buybacks (in EPS). Therefore, when the numerator remains while the denominator declined, the two financial ratios (ROA and EPS) will obviously increase.

Is there any effect of stock buyback on the share price?

Nope. Remember, finance theory already mentioned clearly: “Repurchases do not change stock price”. Although, based on my researches there are actually different arguments exist in this theory due to its theory’s limitations and assumptions. That’s why at the beginning of this example when I created this question, I clearly put there INTI Corp Bhd purchases its own shares at RM5.00 per share which is its market price in the open market. In short, repurchases at market price will not affect stock price. However, stock price will be affected if a company repurchases its shares at apremium (a price higher than the market) or at a discount (a price lower than the market).

The motives of share repurchase (or stock buyback)

• To improve financial ratios by reducing the number of shares outstanding. Buybacks reduce the assets on the balance sheet (cash was used in buybacks), and thus increases the return on assets (ROA) while earnings per share (EPS) increases as the numbers of shares outstanding decreases after the buyback.
• To avoid or eliminate excessive dilution which has the opposite effect of repurchase as it weakens the financial ratios of the company by increasing the number of shares outstanding.
• To avoid or reducing the likelihood from becoming takeover targets/ to ward off any sort of hostile activity.

Important:

Some of the past year examination question related to this topic, directly extracted from my college past year exam paper. The sample answer was provided by the examiner. Ideally, this ‘share repurchases’ question is quite famous in examination as it can easily be tested in two ways: theory and calculation. Somehow, I have seen some question which requires students to compare the advantages and disadvantages of stock buyback with other alternatives to cash dividends such as stock dividends and stock splits.

Notes:

This sharing is not considered as leaking of information, but to increase the diffusion of finance knowledge. Hopefully, this information will be helpful to some students especially for those who are currently taking finance examination.

Related links, additional readings and references:

Stock Market Tips & Facts: What is the stock buyback theory?

http://www.youtube.com/watch?v=C1LwURspJG8

Stock Market : How Do Stock Buybacks Work?

http://www.youtube.com/watch?v=P9xhsIWM7DI

Don’t trust stock buybacks:

http://www.youtube.com/watch?v=OMqzehRw9so&feature=related

The best way for companies to avoid becoming takeover targets is to engage in regular stock buy-backs on the open market.

http://news-releases.uiowa.edu/2008/may/050508buy_backs.html

Stock markets: The buy-back delusion, The Economist

http://www.economist.com/blogs/buttonwood/2011/05/stockmarkets_0