What are share buybacks?
A share buyback is the purchase of a company’s own shares in circulation . The aim of a share buyback is to reduce the number of shares available on the open market. This reduction insupply can lead to an increase in the share price. A share buyback can also prevent other shareholders from acquiring a minority stake. Share buybacks can therefore prevent other companies from buying into the company. If a company wants to take over another company, its own shares can be used as a means of payment. Shares are also used for remuneration purposes. Companies often reward their employees and managers with share bonuses and share options. To offer rewards and options, companies buy back shares and issue them to employees and management. Companies that conduct share buybacks usually have enough cash on hand for emergencies, so the likelihood of economic problems is considered low.
Through a share buyback, a company invests in itself. A share buyback reduces the number of existing shares so that each of the remaining shares has a greater share of the company’s value. You can think of this like a cake: If the pie remains the same size and has to be divided by fewer pieces, the individual pieces are larger. If shares are undervalued, the company can offer its investors a return by buying them back. Earnings per share (EPS) rise, while the price/earnings ratio falls or the share price rises.
How does a share buyback work?
Before a share buyback can be implemented, it must be approved by the Annual General Meeting. In Switzerland, the company may only use freely disposable equity (Art. 659 para. 1 CO) and the total nominal value of the shares may not exceed 10% of the share capital.
One option is to make the shareholders a buyback offer . Theoffer gives shareholders the opportunity to sell all or some of their shares back to the company within a certain period of time. The price is the current market value plus a premium. A second option is the free market. A company can buy its own shares on the open market, provided that sufficient shares are available on the open market. This usually takes place over a longer period of time in order not to influence the share price too much through the purchases and also because sometimes the supply on the market is simply not large enough.
Calculating the buyback ratio allows a comparison of the potential impact of buybacks between different companies. It is also a good indicator of a company’s ability to return value to its shareholders, as companies that regularly buy back shares have outperformed the wider market in the past. The buyback ratio is calculated by dividing the amount of money spent on buybacks in the past year by the market capitalization (number of shares x share price) at the beginning of the buyback period.
Example and effects of a share buyback
Assume that company X has generated a profit of CHF 2 million. There are currently 1 million shares in circulation. The earnings per share (EPS) are therefore CHF 2. If the share price is currently CHF 40 per share, the P/E ratio (share price/earnings per share) is 20. If 5% of the shares are now bought back, i.e. 50,000 shares, there would now be 950,000 shares in circulation. The earnings per share (EPS) would therefore be CHF 2.1. For the P/E ratio to remain constant at 20, the share price must rise to CHF 42, otherwise the P/E ratio will fall to 19.
Disadvantages of a share buyback?
From a long-term perspective, a share buyback does not offer any economic added value at first glance, unless the shares are undervalued at the time of purchase. In addition, it can be detrimental to growth if there are no external investors. A share buyback can give investors the impression that the company has no other profitable, organic growth opportunities, which is a problem for growthinvestors looking to increasesales and profits. If the share price is a performance indicator for the management’s bonus, higher bonus payments must be paid, as the share buyback often has a positive effect on the share price. Share buybacks also put a company in a precarious position if the economy experiences a downturn or the company has financial problems in the form of liquidity shortages that it cannot cover. The money spent through a buyback program could alternatively be held asliquidity, which can be useful in times of crisis.
Conclusion on the share buyback
In principle, share buybacks are a way of returning capital to shareholders. However, caution is advised, as share buybacks only generate a return if the company’s shares are undervalued. Otherwise, value is destroyed when shares are bought back that are already overvalued. To analyze this in more detail, it is worth consulting an expert such as anindependentasset manager.