With the economy showing signs of improvement, share repurchase schemes are once again gaining popularity among corporations and their shareholders. Few options exist for what a business can do with leftover funds at the end of the day.
They can put money aside for a gloomy day, buy back shares of stock in the open market, invest in new property and equipment for the firm, acquire another company, pay off debt, and deliver a special dividend to shareholders.
Stock buyback programs, also known as share repurchase programs, occur when a corporation makes open market purchases of its own shares from existing shareholders. Companies that engage in share repurchase plans may be sending a message to investors that they believe their stock is undervalued.
The Beneficial Elements
1. Increased stock price due to share repurchase program
Financial market participants and Wall Street analysts generally take positive action after hearing that a company plans to repurchase its own shares. Management’s belief that its stock is undervalued might be seen in a repurchase program.
To reduce the number of outstanding shares, a corporation must acquire them on the open market and then deposit them back into the firm’s treasury. As a result, two consequences are occurring; 1.
The value of each share has increased because of the larger stake in the company that it now represents whose underlying profitability and economics have not changed Second, the market forces of supply and demand take effect.
Company employees and possibly other investors are bidding up the price of the stock while fewer shares are being made available. Therefore, according to economic theory, prices should go up.
2. Prevents Businesses From Stockpiling Cash
Companies are nevertheless concerned about the possibility of continued economic turbulence, despite the fact that the economy is improving and starting to recover from the crisis that seized the financial markets in 2008 and 2009.
Like a household’s savings account, many businesses are maintaining a sizeable cushion of cash on hand in the event of unexpected expenses. For investors, a repurchase program provides confirmation that a company is solvent and optimistic about its own and its industry’s long-term prospects.
When a corporation buys back its own stock, it is signaling to investors and other market participants that it sees a low likelihood of future economic and company issues.
3. Share buybacks offer businesses additional options
Without increasing the dividend until it is financially feasible, a corporation can reduce the surplus cash on its balance sheet by buying back its own stock. Like a business plan from an entrepreneur, the strategic growth plans of many corporations detail numerous aspects of the company’s future expansion.
An ever-increasing dividend is one of the many goals that can be pursued as part of a company’s long-term plan. However, if the boost in cash is only temporary, it may be better for the corporation to use the extra cash to repurchase shares from the market rather than try to artificially inflate the dividend yield.
The Negative Elements
1. Share repurchases indicate a lack of future growth.
When a firm buys back its own shares of stock, it tells shareholders that it has no better use for the money.
Growth investors, who buy the company because they anticipate a rapid expansion in sales and profits in the future, are understandably concerned about any plans for a share repurchase program.
A hint to investors that there aren’t many profitable options for growth is when a firm chooses to spend cash on its own shares rather than reinvesting it into the company through capital expenditures or acquisitions of smaller competitors.
2. Businesses Are Not Required To Follow Buyback Announcements
The stock market normally responds positively when corporations declare they will be buying back their own shares of stock. Unfortunately, all it is is an announcement. If the market and economy were to shift, corporations would be under no responsibility to fulfill their stock buyback commitments.
They are under no obligation to continue buying stock. For this reason, a corporation that announces it would repurchase 1,000,000 shares of stock retains the option to repurchase no shares at all or to repurchase only a small number of shares.
In 2007, as the housing market began to collapse, this occurred. Home Depot had planned to repurchase $10 billion in shares but halted the program before market turmoil hit so that it could keep its cash reserves intact.
3. Share buybacks put businesses in danger
Before issuing dividends or repurchasing stock, a corporation should have a good idea that its business is on the correct track to recover or expand. Investors should be wary of a corporation that seems too eager to buy back its stock.
Without sufficient funds, the company will have a hard time being solvent in the event of a downturn in the economy, the occurrence of challenging obstacles, or the occurrence of headwinds within the company’s industry.
This is why many shareholders like their portfolio firms to keep sizable cash buffers to weather revenue dips or operational snafus.
The advantages and disadvantages of share repurchase schemes are similar to those of any other Wall Street practice. An announcement of a share repurchase, on the other hand, is usually taken as a show of optimism on the part of management, both for the company’s future and the economy as a whole.
When a company’s management believes that its stock is undervalued and its future is bright, it can quickly signal this to Wall Street by reducing the number of shares being exchanged.