Are Share Buybacks a Matter of Substance or a Fashion - Essay Example

Are share buybacks a matter of substance or a fashion?   and Section # of The Share Buy Back activity has evolved and overtaken as fashion for some, and trend for others. A far as it is legal and does not harm any other process or organization around it. The act seems to be a harmless one . It is being deemed advantageous for some, and for some, they perceive it otherwise. Introduction ‘As investing jargon goes a share buyback is one of the simplest terms. Its a company buying back its own shares. It can do this in one of two ways. The first, and by far the most common, is when a company buys shares on the open market, just as a private investor does when they buy shares through a broker. A company has to get authority from its shareholders in order to buy back its shares. Usually this is done at its Annual General Meeting. Secondly, and far less common, a company can announce a tender offer. This involves all shareholders submitting a price they would be prepared to accept for their shares. In both instances once the company buy backs the shares it will cancel them, so they will cease to exist. Therefore a company cannot flog the same shares back onto the market at a later date. Why do companies buy back their shares? A company exists to allocate its resources in the most efficient manner for the benefit of its shareholders. Part of its resources may be surplus cash. Surplus cash is cash that it does not require to maintain or expand its business. It may decide to return this cash to its investors. This can be done either by a dividend or by buying back its shares. The decision as to which method is used usually depends on complex taxation issues that we can happily leave to the companys accountants. In recent years there has been increased pressure from investment institutions for companies to return their surplus cash rather than sitting on it just in case they might need it for future acquisitions. The institutions argue that it should be their decision, and not the companys, to hold part of their assets in cash. How does it affect shareholders? As a general rule, share buybacks are good for shareholders. The laws of supply and demand would suggest that with fewer shares on the market, the share price would tend to rise. Although the company will see a fall in profits because it will no longer receive interest on the cash, this is more than made up for by the reduction in the number of shares. In effect you get more pie, as although the total size of the pie is reduced this is more than offset by the fact that you get a bigger slice’1. Popularity of Share Buybacks ‘The popularity of share buybacks has catapulted over the past twenty years. In the United States alone, corporate expenditures on share buybacks as a percentage of earnings are ten times higher today than there were in 1980. In the late 1990s, for the first time companies spent more money repurchasing their shares than on paying dividends. Share buybacks are also flourishing globally. In recent years, countries like the U.K. and Canada have seen an increase in activity while other nations that previous prohibited buybacks, including Germany and Japan, have adopted provisions to make them acceptable. Notwithstanding this surge in popularity, the impact of buybacks on shareholder value—-and hence on the expectations investor—has never been more ambiguous. Under the right circumstances, buybacks provide expectations investors a signal to revise their expectations about a companys prospects. Indeed, share buybacks are a very effective way for managers to increase their companys share price when they have more bullish beliefs about their company prospects than investors do. Yet the signal is not always clear. Buybacks serve a concurrent of interests, which can leave investors with little if any trace of a meaningful signal. Buybacks can be a prime signal that investors need to revise expectations for a companys value drivers. You can rely on the golden rule to measure all buyback announcements: A company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available. Companies cite four primary reasons for buying back stock: 1. To signal the stock is below expected value. 2. To manage earnings per share. 3. To return cash to shareholders efficiently. 4. To increase financial leverage. Investors must critically assess managements motivation for buying back stock. Managers often serve interests other than those of their continuing shareholders.’2 Trend ‘Another example of a bad trend is share buybacks, still another lavish executive options. One of the main reasons why in recent years companies have been buying back their own shares in large quantities is to support their equity’s price and make executive options more valuable. The irony is that many of these purchases are financed not with retained profits but with debt, thereby, increasing a company’s leverage and reducing its creditworthiness in the markets eyes. Companies including financial institutions, go for share buybacks on the false assumption (or excuse) that this improves shareholder value, while in reality it justifies more options to top management at shareholders expense. Share buybacks have also been used as a way of turning a company’s treasury into a gambling outfit. Many companies go into the habit of trading put options on their own shares. Others established a rule that use of inventory limit is set at a maximum of 10 percent shares outstanding, using a corporate plan to reconcile sales of industrial holdings with buybacks. None of the excuses given for these trades is convincing. One of the auditors with whom I spoke about the issues discussed in the preceding paragraphs pointed out that there is a loophole in accounting rules and several companies are keen to exploit it. The effect of share buybacks does not enter group P& L, but is shown directly in the capital account. This leaves many investors unaware for the buybacks aftermath. At the same time though not illegal, such action increases the company’s exposure’ 3. Conclusion ‘Why Stock Buybacks May Not Be a ‘Buy Signal’ Many investors have finally caught on that stock buybacks are a manipulative device used by company management to increase market levels and give value to stock options. Now, there are newsletters that inform short-term traders when companies announce equity repurchase programs. The idea is to buy on the announcement and sell as prices rise. This might have been a good idea ten years ago; it is certainly no longer a sure-fire, get-rich-quick formula. Now buybacks are in high fashion; everyone is doing it and it is becoming difficult to find companies that are not jumping on the band wagon. In 2005, net buybacks totaled $366 billion, and net sales by individual investors (mostly option holders) reached $501.1 billion. The result: instead of stock prices soaring in 2005, sales by insiders exercising options kept the rise to less than 3% for the year. In fact, net stock sales by individual investors have been outpacing stock buybacks for a decade. The only thing keeping the stock market from crashing seems to be naive, long-term investors who continue to buy and hold equity funds through automatic tax-deferred savings plans. The flaw in the buy-on-buyback-notice scheme is market covariance. The buyback program of a single company will not be able to drive prices upwards in the face of a general market downtrend’.4 ‘The phenomenon of UK companies buying back their own shares has exploded in the last five years. But why do they do it? New ESRC-funded research by Dr Steven Young and Professor Dennis Oswald finds that the growth of buybacks is in part a response to recent changes in capital taxation. But the desire to increase earnings per share is also a highly significant motivation. This raises the possibility that managers use buybacks to maximise their compensation rather than to create value for shareholders. Once the sole domain of US companies, the fashion for share buybacks is now catching on with their UK counterparts in a big way. For example, between January 1995 and December 2000, UK firms spent a whopping £34 billion repurchasing their own shares. Firms returned a staggering £9 billion to shareholders through various buyback programmes in the year to December 2000 alone, an increase of over 600 percent on the aggregate value of buybacks made in 1995. Yet despite their increasing economic significance, their motivation and impact remain controversial. If buybacks are perceived to create value for shareholders, then share prices should respond positively to the news that a buyback is on the cards. After adjusting for market and risk factors, Young and Oswald find that share prices rise by 2 percent on average when companies announce they are considering implementing a buyback. So UK investors appear to view buybacks as value-creating transactions. A popular explanation for buybacks is that they enable firms with poor investment opportunities to pay out surplus cash rather than wasting it on value-destroying projects. Because these excess cash flows tend to be fairly volatile, buybacks represent a more flexible mechanism for returning funds to shareholders than dividends. Take for example the retail banking sector where low interest rates, low inflation and internal restructuring have strengthened balance sheets to the point where excess capital has become a major problem. The response of firms such as Barclays has been to return huge sums to shareholders through buybacks. Indeed, over a quarter of all firms cite this explanation among their list of reasons for implementing buybacks. But by far the most frequently cited motive - mentioned by nearly half of all firms - is the desire to increase earnings per share (EPS). The logic goes as follows: buybacks reduce the number of shares outstanding; this increases the earnings available for each share; and this leads to a higher analyst rating. If only life was so simple! And if that wasnt bad enough, the prevalence of EPS-based performance measures in executive compensation plans hints at a more sinister motive: managers may be using buybacks to maximise their compensation rather than to create value for shareholders. No wonder some in the investment community view these transactions with a degree of scepticism. Part of the recent growth in buyback activity can be traced to changes in taxation. Buyback activity increased sharply following the abolition of dividend tax credits in July 1997, after which point buybacks and dividends were placed on a level playing field for tax purposes. The attractiveness of buybacks was further enhanced in April 1999 following the abolition of Advance Corporation Tax (ACT). Prior to this date, standard buyback methods such as open market repurchases qualified as distributions for tax purposes and as such gave rise to a higher ACT charge’.5 Bibliography 1. Motley Fool UK, (1998-2007) Share Buybacks. Fool school. Motley Fool Limited. http://www.fool.co.uk/school/2001/sch011126.htm. 2. Alfred Rappaport and Michael Mauboussin ( 2003) Expectations Investing: Reading Stock Prices for Better Returns, Harvard Business School Press. 3. by Dimitris N. Chorafas, Published 2004, Elsevier,”Economic Capital Allocation with Basel II: Cost, Benefit and Implementation “ 4. Capital Flow Watch, Predicting Markets with Flow of Funds, Why Stock Buybacks May Not Be a ‘Buy Signal’ , Copyright 2003-2005 John Oswin Schroy. All rights reserved. http://capital-flow-analysis.com/capital-flow-watch/why-stock-buybacks-may-not-be-a-buy-signal.html. 5. Professor Dennis Oswald Dr. Steven Young, ESRC Society 2002 : November : Boom Time for Share Buybacks, http://www.esrcsocietytoday.ac.uk/ESRCInfoCentre/PO/releases/2002/november/boomtime.aspx?ComponentId=2133&SourcePageId=1403. Read More