Interactive Investor

Don’t be shy, ask ii...why do companies buy back their own shares?

5th May 2022 11:15

Keith Bowman from interactive investor

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Mr Parsonson asks: I’m constantly puzzled about the intended positive effects of companies buying back their own shares. I own shares in Lloyds Banking Group (LSE:LLOY) and Vodafone Group (LSE:VOD), and since buybacks were put in place the growth in these share prices is minimal or even negative. To a lesser extent, even BP (LSE:BP.) is not near its more recent highs in 2021, and that is despite oil trading at $100 per barrel. I just wonder if this means the underlying sentiment for all these stocks is negative and the buybacks are merely defensive in terms of minimising, what might have been, significant share price declines. 

Keith Bowman (pictured above), Equity Analyst, interactive investor, says: share buybacks are simply one of many ways that companies can hand back surplus cash to their shareholders as an alternative to cash dividends.

The process refers to when a company buys back some of its own shares in the stock market, then cancels them. This means there are now less shares in that company available for other investors to buy, which should help boost demand and therefore the share price. 

There will typically be a beneficial effect on the earnings per share (EPS) and dividend per share figures which will now be calculated using a smaller number of shares. That means, all things being equal, the numbers will be higher. A higher EPS will give a lower price/earnings (PE) ratio, a key valuation metric, making the shares appear cheaper. 

They are often used as an alternative to dividend payments because the cash is surplus and beyond what management forecasts might be generated in the future and required to fund dividends. 

Companies understand that investors dislike cuts in dividends and ideally seek a smooth progressive increase overtime.

Management might decide to buy back shares because they think they are undervalued, implying confidence in the business. 

But share buybacks are not a panacea for issues or challenges that the company may be facing, whether they be internal, company-specific or a macro event. If a business is performing badly, or the investment community perceives it to be a poor home for their cash, the shares will underperform, with or without a share buyback programme in place.

A company that has committed to regularly buying back its shares might provide a degree of support for the share price, but can't guarantee that the price won't ever go down. 

Buybacks can also suggest that a company is struggling to think of anything better to do with its excess cash. In some instances, this can be worrying and be perceived as a company lacking investment ideas to utilise the cash to generate future profits, whether that be investment in the business or on acquisitions. 

However, effectively giving back the cash to shareholders in the form of higher earnings via a share buyback, may prove a better alternative to management rushing to spend surplus cash on a misjudged investment or even an overpriced acquisition. 

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