The impact of share repurchase on markets

The impact of share repurchase on markets

gabriel2

Gabriel Brisson-Guérin

Intern, Investments

gabriel.brisson-guerin@bluebridge.ca

Since the late 1990’s, share repurchases have been continuously growing in popularity among public companies. That is, companies can buy some of their shares back from the market, thus reducing the current number of shares outstanding. Share repurchases are perceived as a way for companies to return money to their shareholders similar to dividends. However, as we can see below in Figure 1, the number of shares outstanding for the S&P 500 has significantly been decreasing over the past 7 years and this is mainly due to share buybacks.

Buying back shares and taking them out of the market has many impacts on a company’s valuation. First of all, a popular metric used by investors is affected, the price to earnings ratio (P/E). This ratio tells investors how many times a stock is trading relative to its earnings, giving an idea as to how expensive a stock is. Since the earnings of a company is not directly affected by the number of outstanding shares, buying back shares will increase earnings per share. If the price of the stock remains unchanged, the price to earnings ratio will then shrink thereby making the stock appear cheaper.

Various balance sheet ratios are also impacted positively by this transaction. These ratios are often used to evaluate the quality and profitability of a company. Companies use some of their assets (cash & equivalents) to buy back equity, thus reducing assets and equity. Return on equity (ROE) calculates a company’s profitability relative to its equity. As we know, the earnings won’t be affected by the buyback, so the return on equity ratio will increase. The same thing is true for the return on assets (ROA) ratio.

Now that we’ve explored some effects of buying back shares, let’s see why companies pursue such a tactic. Firstly, it is a way to return cash to their shareholders, even if it is riskier than dividends. Dividends are a current payoff whereas share buyback reflects a future payoff. Typically, the price to earnings ratio of a company tends to revert to its mean, therefore when a company repurchases shares and reduces its P/E ratio, it expects the share price to go up and meet its historical P/E ratio. It has been true in the past if we compare the return of the S&P buyback index (an index that measures performance of the 100 companies with the highest buyback ratio) and the S&P 500 index. Between 2003 and 2013, the S&P buyback index outperformed the S&P 500 index by 90 %[1]. Recently, this hasn’t really been true if we look at the annualized return on a 5-year period, which is 7.64% for the buyback index and 8.49% for the S&P 500[2]. This is partially due to value stocks struggling, but it might be an indication that markets have changed and share buyback is currently being overused. Another reason why companies engage in share buyback is because they believe their stock is undervalued by the markets and they don’t see any better investment opportunities for the use of their current cash.

A cynic might point out that the rationale behind share repurchases has not been very successful recently because companies misuse the practice. Indeed, some companies don’t pay enough attention to the value of their stock when initiating a repurchasing program, seeing as they want to make their ratios look more attractive, and as such, end up buying their shares when they are overvalued. Other companies might resort to share buybacks solely to meet their EPS target guidance, trying to hide their miss from investors. This is a rather poor way to use share repurchases, which will eventually drive the stock price down.

Shares repurchases can be a good way to return cash to shareholders, nevertheless they remain much riskier than simply distributing dividends. Investors need to closely evaluate if a share repurchasing program is appropriate for those companies who announce it. The recent rise in popularity of share buyback is partly responsible for the continuous rise of the equity market over the past few years and its richness, measured on a price to earnings basis. We will see if companies continue to recklessly implement repurchasing programs or slow down and re-think their strategy.

 

 

Sources:

https://seekingalpha.com/article/4250756-buybacks-making-market-look-cheaper

https://corporatefinanceinstitute.com/resources/knowledge/finance/share-repurchase/

https://www.fool.com/knowledge-center/does-a-stock-buyback-affect-the-price.aspx

https://www.investopedia.com/articles/investing/112013/impact-share-repurchases.asp

https://seekingalpha.com/article/4255416-dividends-buybacks-s-and-p-500-buyback-index-outperforms

[1] https://www.investopedia.com/articles/investing/112013/impact-share-repurchases.asp

[2] https://seekingalpha.com/article/4255416-dividends-buybacks-s-and-p-500-buyback-index-outperforms