SHARE BUYBACKS
What and Why
Ever wonder why some companies buy back their own shares? It's not just a random move—they've got their reasons. Let's dive into why companies do this and what other options they have. To show these different policies in practice, we took the case of Smartphoto – a company active in the personalized gift industry. For a deep-dive in the details of Smartphoto, we happily refer you to the this report:
First things first: Where does the money for buybacks come from? Companies generate cash through their everyday operations. After covering essential expenses, like investing in equipment for maintenance or growth, they’re left with "free cash flow." Now, they can do one of three things with this cash: (1) invest in growth projects, (2) stash it in their cash reserves, or (3) return it to shareholders. Returning cash to shareholders can take the form of dividends (a cash reward for holding the company’s stock) or share buybacks.
So, why don’t companies just hold onto their cash? Well, they usually avoid stockpiling cash unless they really have no better option. If there’s a project with a promising future return, they’d rather invest in that, as it could boost the company’s prospects. But since the future is unpredictable, figuring out the potential returns of these projects can be tricky.
If there are no good projects on the horizon, companies might choose to return the cash to investors. But why give cash back to investors instead of keeping it? For many investors, getting a return on their investment feels like a reward for trusting the company. Companies that pay dividends are often (perhaps unfairly) seen as more reliable. In essence, the company is saying, “We don’t have any exciting projects right now, so here’s your cash back—maybe you can find a better place for it.” This return can happen through dividends or share buybacks.
With dividends, companies have two options: (1) a cash dividend or (2) a scrip dividend. The difference between these isn't crucial for this discussion. As for buybacks, there are also two options: (1) burn the shares, reducing the total number of shares and making each remaining share more valuable, or (2) hold onto the shares in the company’s treasury, essentially betting on themselves. The first option is the most common, while the second is used when a company sees itself as undervalued and is planning future acquisitions. In Smartphoto’s case, the shares are stored in treasury, indicating the company feels like they are undervalued. Even more, Smartphoto has been doing a few acquisitions in the past few years. The buy-back of their own shares has therefore even led to active value-creation within the company.
Even though many investors prefer dividends, share buybacks still happen—so why is that? Dividends are favored not just for the money, but also for the signal they send. Studies show that announcements on dividend increases influence stock prices more positively than announcements on share buybacks. These results show that dividends have the power to send a positive signal on a certain firm (Anderson & McLaughin, 2013). Generally, growing dividends suggest that the company is thriving. But once a dividend is paid, the cash is gone. In contrast, buybacks have a lasting effect: after shares are burned, future profits are spread over fewer shares, making each one more valuable. Another reason for the longer-term effect of share repurchases is the following: firms use these type of transactions to signal undervaluation to the market (Chen et al., 2011).
Another difference between the two types of “investor rewards” depends upon the investor preferences, which are partly determined by the current tax regimes. Dividends are usually taxed using a so-called “withholding tax” while share repurchases generally lead to a capital gain and therefore are taxed under a capital gain tax. The difference in how both of these taxes are applied and their rate plays an important role in shaping investor preferences. As firm generally want to please investors, they will try to cater as much as possible to these investor preferences, which could influence the decision to either buy back shares or pay out ordinary dividends.
Ultimately, the decision between dividends and buybacks comes down to a cost-benefit analysis by the company. It depends on factors like the costs of each option, investor preferences, tax implications, and the emotional comfort of perceived safety. In the end, it’s all about balancing these factors to make the best choice for the company and its shareholders.
References
Bonaimé, A. A., & Kahle, K. M. (2024). Share Repurchases. Edward Elgar Publishing. https://doi.org/10.4337/9781800373891.00011
Krotova, T. G. (2023). Managerial Market Timing Under Credit Risk: How Do Timed Buybacks and Stock Issuances Influence the Value of Long-Term Shareholders?. Global Finance Journal. https://doi.org/10.1016/j.gfj.2023.100807
Chen, T. Y., Kao, L. J., & Lin, H. Y. (2011). The Long-Term Wealth Effect of Share Repurchases: Evidence from Taiwan. Social Science Research Network. https://typeset.io/papers/the-long-term-wealth-effect-of-share-repurchases-evidence-1we0oqfukk
Manconi, A., Peyer, U., & Vermaelen, T. (2019). Are Buybacks Good for Long-Term Shareholder Value? Evidence from Buybacks Around the World. Journal of Financial and Quantitative Analysis. https://doi.org/10.1017/S0022109018000984
Larsson, D., & Benavides, R. R. (2019). Dividend or Stock Repurchases? US 2012 Tax Increase and Its Implication on Payout Policy. https://typeset.io/papers/dividend-or-stock-repurchases-us-2012-tax-increase-and-its-nx6w0hf4ki