StarBiz - "Under normal circumstances, investors should get excited when companies buy back their own shares. In theory, this action implies the management views the best available investment opportunity for the utilisation of excess cash is to invest in its own company rather than buy into some other companies.
This is because when a company buys back its own shares, it will reduce the firm’s outstanding shares and enhance the company’s earnings per share (EPS).
Due to information asymmetry, the management is in the best position to determine that the company is being undervalued at the current price and, thus, it is to the best interest of the shareholders to buy back the company’s shares.
Hence, in general, we can conclude share buybacks usually convey a positive signal that implies the stock of a company is underpriced."
Share buybacks on its own does not reduce the firm's outstanding shares because they are not canceled. The shares outstanding remain the same whether a company buys them back or not. Hence, it is also true that share buybacks does not enhance the company's EPS as well. Considering that 99% of all Malaysian listed company share buybacks do not result in shares cancelation but are kept as Treasury shares - there is NO improvement in EPS.
What should investors’ opinion be of these share buybacks? Should companies make known their intentions?
We need to understand first why there is a stockmarket in the first place? First and foremost, it is there to allow companies to raise cheap funds to fund their growth strategies. Secondly, it is to allow for individuals and other entities to participate in the growth of these companies. Other reasons are secondary in nature. A company raises funds to facilitate corporate strategies, hopefully they will make money, preferably higher than the prevailing interest rate (if not, all funds should put money in the bank and close shop). Successful companies may keep accumulating profits to prepare itself for two general reasons: market down cycles, or in order to take advantage of opportunities when there is a market/industry correction/sell-down.
Companies should only indulge in share buybacks when accumulated funds are in excess for the above two reasons. This is because share buybacks will deplete reserves and may not be easily convertible to cash when there is a downcycle or market correction – the time when funds may be needed for those two purposes. Companies doing share buybacks must and should consider this aspect before embarking on the said exercise. Even then, the company can still decide on other options to do with the excess cash – give back to shareholders in the form of dividends or bonus – especially in a matured industry.
Companies raise cash for investing in growth, if they find no good investing opportunities after a prolonged period and cash flow is healthy, the funds should be returned to shareholders. Companies doing share buybacks are basically saying that that is the best way to spend their excess cash. To arrive at that decision, they must be convinced that their share is undervalued compared to their company's prospects. A company’s share price may not reflect its true potential – who knows the company’s fundamentals better than the people running them.
Then we have to look at why management is doing this – is it to improve share price via reducing the free float; and/or improve the earnings per share (but that only happens when they cancel the shares). If a company has to resort to improving their share price by reducing free float, it is usually not successful – a simple glance at the past 2 years' price performance of most of these companies will tell you that. By reducing free float, it is a futile exercise as the company will have to accumulate a significant amount to prop up the share price – that seems artificial no matter how you look at it as the only group really keen to own the shares is the company themselves.
Of course, share buybacks can successfully engineer higher share prices by massively reducing free float but they will have to meet regulations for minimum free float in the market place. The danger is that share buybacks can be taken advantage as “insider trading” by management as it involves market timing – hence the authorities must be more vigilant when it comes to the timing of share buybacks. If a company buyback the shares and do not cancel them, are they waiting to unload when price is higher? That is tantamount to trading in their own shares or having an investment portfolio. Is that part of the company’s normal course of business? Can this activity account for a substantial amount of profit for the company? How should analysts regard this profit – probably not enthusiastically as it is considered as a “one-off.”
It is safe to say that companies should make their intention known to the public when doing share buybacks – is it for future placements to institutions; to be canceled, if so please state a time frame; not to be canceled, but to be sold back into the market when price is higher; or to be disbursed as bonus. To me, that is vital information and I believe investors will rate the stock accordingly with the new information.
Bottom line, if it is not going to be canceled, share buybacks are not really that big a positive in rating the company. Most times, companies who do share buybacks will not see significant improvements in their share price – investors do not rate a company higher because of that as investors are not buying the stock in the first place for various other reasons, and the freefloat is not really a major reason. Any worthy share buyback has to be canceled for it to be effective.
Companies not doing that, need to ask themselves more questions as to why their share price is not at a level where it should be – are investors not happy with the management’s vision; is the company not communicating its plans effectively; has the company not been able to chart a credible track record; have the financial results for the company been haphazard or inconsistent; is the company too unfocused or too diverse that nobody even wants to follow/research the company; how is the management track record been in treating minority shareholders; have transactions or deals been really fair to all shareholders or been forced down investors’ throat (oops, getting too specific here) – chances are the stock will be rated properly if the above concerns have been addressed. Hence most share buybacks will not be entirely successful as it is fighting against the “enemy” when the “enemy” is really internal not and not external.
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