By Jackie,
Researcher
Topic:
Education
Area of
discussion: Finance
Chapter:
Dividend policy
Subchapter:
Alternatives to cash dividends - Share repurchases
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?
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
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).
- 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.
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.
Stock Market
Tips & Facts: What is the stock buyback theory?
Stock Market : How Do Stock Buybacks Work?
Don’t trust
stock buybacks:
The best way for companies to avoid becoming takeover
targets is to engage in regular stock buy-backs on the open market.
Stock
markets: The buy-back delusion, The Economist
