Buy back in trading: what is it and how does it work

What is buy back, how does share buyback work and why do listed companies choose to do it?

When you decide to proceed with a buyback, the consequences can be different.

Through the buyback, in fact, the company in question repurchases part of its shares on the market and then cancels them, since it cannot be a shareholder of itself, with the objective of reducing the number of shares available on the market and increase the value of the remaining ones.

Let’s find out what buyback is, how it works, the meaning of the term, and the ways in which this operation can be carried out.

Buyback at a glance

In short:

• Buyback occurs when a company buys its shares in the stock market;
• The buyback reduces the number of outstanding shares, thus increasing the earnings per share and, often, the value of the shares;
• The share buyback increases the optimism of investors, who see that the company has a good amount of set aside liquidity at its disposal.

Buyback: what is it?

Buyback means the repurchase of own shares and occurs when a company buys its outstanding shares to reduce the number of shares available in the market.

Companies buy back shares for a variety of reasons, such as increasing the value of the remaining shares, by reducing the supply, or preventing other shareholders from acquiring a controlling stake.

Through buyback, the company has the opportunity to invest in itself. By reducing the number of shares on the market, the repurchase operation makes it possible to increase the value of the same, given that each investor of that company will find himself holding a greater percentage as the total number of shares available on the market has decreased.

The buyback, consequently, also increases the percentage of earnings due to each individual share, which therefore increases in value provided that the price/earnings (P/E) ratio remains stable. The stock’s earnings per share (EPS) increases as the price/earnings (P/E) ratio decreases or the stock price increases.

The operation then gives investors a certain optimism: the buyback, in fact, demonstrates to the market that the company has sufficient liquidity to implement this type of instrument, and consequently its shoulders are broad in the event of economic problems.

Finally, another reason that drives listed companies to resort to buybacks is for the purpose of compensation. To offer its employees and executives stock bonuses and stock options, the company buys back shares and sells them to them, avoiding dilution of existing shareholders.

How does buyback work?

There are two ways in which the buyback operation of treasury shares can be carried out. In fact, we can speak either of a direct offer, also known as a tender offer, or we can refer to a purchase on the market.

• Direct offer: in this case, with the buyback, the company offers shareholders to buy back a certain number of shares at a price range that is established within a given time frame. It is the most common practice.

• Purchase on the market: in this case the buyback of treasury shares by the company takes place in the manner used by any investor, i.e. at a price established by market dynamics (supply/demand match). This second buy-back method is generally little used by companies because as soon as the news is released, the share price skyrockets.

The buyback, or repurchase of treasury shares, follows a precise scheme that is divided into stages:

1. the company repurchases some of its shares;
2. these shares are reabsorbed and cancelled, since the company cannot be its own investor;
3. the cancellation reduces the number of shares on the market;
4. the fewer shares there are, the more their value increases;
5. having increased their value, each shareholder has a larger slice of the company and therefore a greater profit.

Why do companies buy back

A company listed on the market decides to conduct a buyback operation on the basis of various motivations, some of which have already been mentioned above:

• Excess Cash: The company believes that its excess cash may be more profitable if invested in its own shares, rather than used in bank loans or reinvested. In this case, the company behaves like an external saver who decides to carry out an investment in its own stock.
• Shareholder value: since a buyback operation:
  • increases the quotation of securities, as it supports the demand on the market;
  • increases the asset value of the remaining securities, if the securities subject to buyback are destroyed;
• Maintenance of the majority stake, absolute or relative, of the shares, and therefore of the control and ownership of the company, since the shares repurchased by the issuer leave the stock market and cannot be subject to a public purchase offer ;
• Get a capital gain: the company buys shares at historic lows to resell them on the market, as soon as prices return to pre-crisis levels.

The objectives of the buyback

As already emerged in the previous lines, buyback operations are used to implement:

• Stock option plans: the attribution of shares to employees and/or directors of the company implies that the company must acquire share packages.
• Distribution of shares or other free or paid share options, to employees and directors of the issuer or its subsidiaries.
• Exchanges of shares with other joint stock companies, as part of transactions of a strategic nature of interest to the issuers.
• Stock valuation: the buyback can also give an important signal to the market as to how the directors believe the stock is undervalued. If this signal is received, agents could invest in that stock and drive prices up.

Following the 2008 crisis, buyback operations also spread to other financial instruments such as bonds, and to public law entities, with the repurchase of sovereign debt securities by Central Banks.

In these cases, the operation is aimed at:

• prevent bonds from remaining unsold in the auction with institutional investors;
• place the securities with lower interest: by increasing demand, the overall cost of public debt decreases and remains repayable even in the long term.

The consequences of the buyback

Buyback operations are quite convenient if you look at their consequences on the company’s indices. The repurchase of treasury shares, and therefore their reduction on the market, increases the share of the company and the profit of each shareholder. In other words, it increases their Earnings Per Share (EPS).

Also improving are the Return on Equity (ROE) and the Return on Investment (ROI): in this last case the number of assets is reduced and therefore the denominator of the ratio necessary for the calculation.

Example of buyback

Despite having a pretty good fiscal year, company X considers its stock undervalued relative to its major competitors. To remunerate one’s shareholders in the long term and raise the value of the shares, decide to proceed with a buyback operation aimed at repurchasing 10% of one’s own shares.

X shares are in total 1 million and the total profits are equal to 1 million euros. Consequently, the EPS (earnings per share) is 1 euro. The Price/Earning ratio is 20, so the shares trade at 20 euros each.

EPS = 1,000,000 profits/1,000,000 shares = 1 euro

As mentioned, the company wants to proceed with the buy back of 10% of its shares, which in our example corresponds to 100,000 shares (out of 1,000,000). The new EPS will be increased from 1 euro to 1.11 euro since it will no longer have to be calculated on one million shares but on 900,000.

New EPS = 1,000,000 earnings/900,000 shares = €1.11

With a P/E ratio of 20, the value of the shares will not be more than 20 euros each, but 22.22 after the buyback, i.e. after the repurchase.

1.11 x 20 = 22.22 euros per share

Original article published on Money.it Italy 2023-05-23 10:56:24. Original title: Buy back: cos’è e come funziona il riacquisto azioni