What is a Stock Repurchase?
A company repurchasing its own stock, commonly referred to as a ‘stock repurchase,’ occurs when a company buys back some of its outstanding shares from the public. This activity reduces the amount of a company’s outstanding stock and increases the value of the remaining shares that the company owns. Companies are usually motivated to repurchase their own shares if they feel the stock is undervalued by the market or if they want to establish a certain price floor for their stock.
Why A Company Repurchases Its Own Stock
Companies routinely repurchase their own stocks for a variety of reasons. Firstly, management may feel like the company’s stocks are currently undervalued by the market and thus is an opportune time to take advantage of an attractive price by repurchasing. It gives the company an opportunity to accumulate more equitable ownership of its own stock, bringing down the amount of outstanding shares and rejecting the incorrect perception of the market that the company’s share price is discounting.
This process ultimately improves the return on investment for the company’s existing shareholders, as the same earnings will be distributed over a smaller share base. In this case, the shareholders’ ownership stake in the company increases, as does the premium of their individual shares. This increase in per-share worth also gives the stock a higher price-to-earnings ratio, which can improve the perception by outside investors that the company is being managed well.
Additionally, stock repurchases are often an effective utilization of the company’s excess cash. This can be particularly beneficial when compared to other options such as dividend payments, as stock repurchases can benefit existing shareholders without corresponding taxes that dividends carry. It can also give the company more financial flexibility since the cash is not tied up for long periods of time the way it is with a dividend payment.
Risks of Repurchasing Stock
While stock repurchasing can be a wise move for a company, there are still potential drawbacks. The main risk is that repurchasing stock is typically done with retained earnings or existing funds, meaning there is money that could have been used for other purposes. Furthermore, since the company is typically not able to issue or raise these funds elsewhere, their ability to repay debt or invest in research and development may be hindered.
Another risk is that stock repurchases can lure outside investors into the market and overextend the demand for a company’s shares. This may potentially lead to the company buying back stock at abnormal prices or investing in shares beyond the intended rate. This in turn can lead to wasted capital and missed opportunities within the company, as the additional cash is now being utilized for a function that serves fewer people.
The Effect of Stock Repurchases on Stock Performance
One of the main purposes behind stock repurchase activities is often to increase a company’s stock price, which can lead to improvement in stock performance if successful. In the short term, an announcement of potential stock repurchases can increase the company’s share price, since the market considers it to be a positive sign of the company’s potential performance.
In the long run, since the company is reducing its share base, this often leads to a higher dividend yield. This in turn, increases the demand for the remaining shares and thus the share price appreciates, improving the stock performance. That being said, stock repurchases will not automatically improve the performance of a company’s stock, as other factors that influence the performance of a company’s stock, such as performance and outlook of the company and the overall market conditions, can play a major role.
The Legalities of a Stock Repurchase
Although stock repurchase is a generally accepted practice, companies must still comply with all the relevant legal regulations when attempting to repurchase its own stock. Regulations vary by jurisdiction and are subject to change. In short, companies must take all the necessary steps to ensure that all the shareholders are treated fairly and equally throughout the stock repurchase process.
In particular, companies must be aware of insider trading regulations and disclose any relevant material information that may affect the stock price in order to prevent any disagreements. Additionally, companies must abide by the applicable securities laws, labor laws, filing requirements and even environmental regulations.
Strategies for Implementing a Stock Repurchase Program
Management must take several factors into consideration when determining the ideal timing for a stock repurchase. Typically, investors will not likely be supportive of a repurchase if the company is performing poorly or if there is the potential that the stock repurchase is being implemented to mask financial difficulties that the company is experiencing.
When repurchasing stock, the company may decide to purchase the stock either in the open market or through a tender offer. With the former, the company will buy the stock based on the prevailing market price, while in the latter the company will set a predetermined price, commonly higher than the market price, and allow shareholders to decide whether they want to tender their shares.
Financing a Stock Repurchase Program
Companies typically fund their stock repurchase program from the profits they have earned up to that point. However, a company may decide to raise additional funds from
outside sources to finance the repurchase. This is usually done through the issuing of debt or equity securities.
When issuing securities, a company must ensure that it does not breach any debt covenants that have been imposed by the lenders, such as the limitation of debt. Another way to generate more cash is to sell some of the company’s assets, as this could provide the cash needed to repurchase stock without incurring debt.
Market Reaction to Stock Repurchases
When a company’s stock repurchase plans are made public, the news is usually welcomed by investors, as they consider it a sign of the company’s confidence in their stock price and the management’s intention to increase shareholder value. The short-term effect of this news can lead to an increase in the stock price owing to the increase in demand for the stock.
However, whether a repurchase activity results in an increase in the stock price over a longer period of time is largely dependent on the market’s perception of the company’s fundamentals, along with the macro-economic conditions. Additionally, the offshore sentiment related to the company or the sector that the company is in can also influence the demand and supply of the company’s stock.
Analyzing the Effectiveness of Stock Repurchases
It is not enough for companies to simply conduct a stock repurchase and then forget about it. They must continuously monitor its effect on the stock price, review their decision regarding the repurchase and analyze how it is impacting their overall finances. Companies should investigate which areas of their spending the stock repurchase is impacting, and make necessary changes to those areas that may be hindering the growth of the company.
Moreover, a company must consider factors such as the earning potential, the liquidity of the company, the operating performance and the overall outlook of the company when considering a stock repurchase. Companies should also develop a transparent and permanent stock repurchase policy to ensure that all shareholders have adequate information about the repurchase process and the potential outcomes it could have.
Evaluating the Short-term and Long-term Results of a Stock Repurchase
Companies need to develop a methodology to evaluate the effectiveness of the stock repurchase activity both in the short-term and in the long-term, including an assessment of the impact on the stock price, total shareholder return and earnings per share.
In the short-term, it is important to consider the direct financial impact, such as the cost of the repurchase relative to the current market price and the amount of cash generated from the program. Whereas, in the long- term, companies must consider the efficiency of their stock repurchase program over time, and the impact on other shareholders’ investments and the overall economic performance of the company.
Reviewing Financial Performance of Stock Repurchases
Regular reviews and certifications of the financial performance of stock repurchases are necessary for companies to identify where improvements can be made in order to ensure that the repurchase program is meeting its intended goals. Companies must also be vigilant in ensuring that the same due diligence is performed on all the transactions made during the repurchase program – such as evaluating the risks of engaging in the repurchase and considering alternative methods to use the funds.
Finally, companies must ensure that any repurchase program is transparent and fully disclosed to the public to forestall any potential legal repercussions. Companies must also regularly communicate with their shareholders on the status of their stock repurchase programs, so that any questions or concerns the shareholders may have are addressed.
