Looking Behind A Share Buy-Back

Ser Jing - There's More Than Meets the Eye With Steady Dividends (pic) A company can do a few things with the free cash flow it churns out yearly. It can reinvest the money into its business, use it to pare down debt, pay dividends or to buy back its own shares.

There are a few reasons why companies buy back their shares.  One of the reasons is that it does not see other uses for the cash that it decides to buy back its shares. However, the company has to ensure that it doesn’t buy backs its shares when it is exorbitantly priced. By repurchasing shares when the price is overvalued, the company is not creating value to its shareholders. Returning the cash as dividends to its shareholders would make more sense.

Another reason for repurchasing shares is that it is better than paying out dividends to shareholders. We are blessed in Singapore to have no dividends tax, so this would not apply for local companies. However, investors in countries like the United States are not so fortunate. In fact, there is double-taxation on the part of shareholders. The first taxation occurs when it must pay taxes on its earnings. The second taxation occurs when the shareholders receive the dividends. The shareholders pay taxes first as owners of a company that brings in earnings and then again as individuals, who must pay income taxes on the dividends received. Therefore, some companies deem it is better to buy back its shares rather than pay out dividends, which may be detrimental to the shareholders.

Warren Buffett is a huge advocate of companies buying back shares. He believes share buybacks can reveal a thing or two about the company’s management. He once said, “What you’d like to do as an investor is hook them up to a machine and run a polygraph to see whether it’s true. Short of a polygraph the best sign of a shareholder-oriented management — assuming its stock is undervalued — is repurchases. A polygraph proxy, that’s what it is.”

The third reason for buying back shares is to prop up the share price or to provide a support to the share price. By reducing the number of shares outstanding, the earnings per share will increase. This causes the PE ratio to fall due to a larger denominator. The share price should then rise as market sees the share price as cheaper than before the repurchase. The ROE and ROA of the company should also increase after share buyback since there is lesser outstanding equity and cash (assets) respectively in the balance sheet.

Some locally-listed companies that did share buybacks for the week from 1st July 2013 to 5th July 2013 include DBS Group Holdings Limited (SGX: D05), Popular Holdings Limited (SGX: P29), Oversea-Chinese Banking Corporation (SGX: O39), HupSteel Limited (SGX: H73) and AEM Holdings Limited (SGX: A10).

Prudent investors interested in purchasing shares in a company that is conducting share buy backs should take a closer look at the reason for a company to buy back its shares, and the implications of doing so.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore contributor Sudhan P owns shares in HupSteel.