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Are Share Buybacks Good For Shareholders?

Companies frequently do share buybacks to deploy excess cash, and such an exercise may also signal that the shares of the company are undervalued. Aside from the cosmetic aspect of such actions, is there any real value to be achieved by buybacks? I explore several implications for companies which regularly buy back their shares.

Deployment Of Excess Cash

Some companies may face the problem of burgeoning cash reserves, as the business is cash-generative and the cash keeps building up on the balance sheet. While this is a “happy problem”, shareholders are likely to complain if too much cash builds up, as it would erode the overall returns of the company as cash earns a paltry return.

Management could then deploy this excess cash (“excess” being defined as cash which exceeds the level required by a company for maintenance and normal operating expenses) for share buybacks. Buying back shares is viewed as a productive use of cash if and only if the cash cannot be deployed into projects which can earn a better return. The stocks which have been repurchased by the company are then parked as “Treasury Shares” under the “Equity” portion of the balance sheet.

Enhancement of Earnings Per Share

Buying back shares enhances the earnings per share for the company, as there is now a smaller base of shares to act as the denominator when computing earnings per share (defined as “net profit after tax attributable to shareholders” divided by total issued share capital).

Lower Dividend Payments

Note that dividends do not have to be paid on treasury shares, therefore if the company declares the same dividend per share year on year, but has a lower number of shares in issue, this means that it has to cough up a lower amount of cash for dividends.

Employee Share Options Plan (ESOP)

Some companies use treasury shares as bonuses and incentives to reward employees who have performed well, as part of the ESOP. Many companies adopt formal ESOP plans where employees are awarded share options upon the achievement of certain financial or operational targets. These options allow them to buy the shares at a specific price so that they can own a piece of the company they work for.

Signalling

Share buybacks can also act as a subtle form of signalling. The company is, in effect, trying to let investors know that it has a large cash hoard and that it is willing to deploy this to buy back shares. Companies with savvy management teams may also send the signal that its shares are undervalued by doing frequent share buybacks.

The Foolish Bottom Line

For the reasons stated above, share buybacks are beneficial in many ways for companies. Except in cases where the company needs the cash for other purposes or if they buy back the shares at expensive valuations, otherwise, share buybacks, in general, are a good sign for shareholders and should be lauded.

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice.