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FOOL SCHOOL
Share Buybacks

August 5, 2005

As investing jargon goes a share buyback is one of the simplest terms. It's simply 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 company's 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 company's, 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.

Numbers please!

Let's say our company makes £10m in profits each year, of which £1m comes from interest on its cash pile of £30m. It has 100m shares in issue therefore its earnings per share is 10p (£10m/100m).

Let's also assume that the share price is 200p, meaning that investors have awarded the company a price earnings ratio of 20 times (200p/10p). OK, what happens if the company uses all of its £30m in cash to buy back its shares?

In total it can buy 15m shares (£30m/200p). Because it is no longer receiving interest on its cash balance its profits will fall to £9m. These profits will be split between the remaining 85m shares. Therefore its earnings per share will rise to 10.6p (£9m/85m). Assuming that investors still think a price earnings ratio of 20 times is appropriate, they might be willing to pay 212p for the shares.

In practice, however, they might be willing to pay even more. That's because the company's profits will grow faster now that the slow-growing cash element has been taken out. But they may also perceive that the company does not have great growth prospects because it cannot profitably invest its £30m spare cash. In that case they might be willing to pay less. So although the price should move higher in theory, the actual outcome will also depend on how the market perceives the slimmed-down company.

It's worth noting that the cheaper the shares, that is the lower the price earnings ratio, the greater the increase in earnings per share caused by the buyback. Had the share price been 100p the £9m in profits would have been carved between just 70m remaining shares, resulting in earnings per share of 12.9p.

Had the shares been valued at 300p earnings per share would have remained at 10p, as the £9m in profits would have split between 90m remaining shares. You could have worked out this 'equilibrium' price by noting that, at 300p, the price earnings ratio is 30. This number is the same as the £30m cash pile divided by the annual interest of £1m.

So a company is much more likely to buy back shares when it sits on a low price earnings ratio. As it also needs a lot of surplus cash to make a buyback worthwhile, it is much more likely to be mature businesses that buy back their shares.