Buyback of shares

Share buybacks are fairly common in mature stock markets, but investors are often unaware of how they can use this phenomenon to generate short-term profits. Buybacks are generally viewed as a bullish indicator, but be aware that there are some risks involved in trying to play this action.

Terms and definitions

So, lets start with the definitions. A buyback is the purchase by a company of its own shares previously placed on the open market. The shares in this case are called "redeemed" or otherwise "treasury" shares (in English it sounds like treasury stock). The following are definitions of several important terms that we will use when discussing the issue.

Authorized capital, or authorized shares (eng. authorized shares) are those shares that a company has the right to issue in accordance with its charter, decision of the board of directors or a meeting of shareholders. However, not all of them are traded on the open market.

Outstanding shares (eng. outstanding shares) are company shares owned by investors (and not only external, but also employees and senior officials of the company). They do not include "repurchased" and "authorized but not issued" shares.

Repurchased shares are shares previously outstanding but repurchased by the company in the market. Subsequently, they can be sold again, or, on the contrary, they can be withdrawn from circulation altogether - of course, on the basis of a decision taken by the shareholders.

Finally, Float (already a clean copy of the English word float) is the companys shares in "external" circulation, that is, all shares minus:

• belonging to the so-called insiders (highest officials of the company);
• "redeemed" shares.

The main indicator that market participants pay attention to when they are interested in the shares of a particular company is "earnings per share" (eng. earnings per share, abbreviated as EPS), then is the value obtained by dividing the profit by the number of shares outstanding.

Impact of buyback on profit

Now that the definitions of the necessary terms are given, we will try to find out how buyback can affect (both positively and negatively) investors profits - and why companies resort to it at all.

For shareholders, the value of buyback is determined by the share of shares to be bought back - the higher it is, the greater the chances of making a significant profit. Often, a share buyback announcement is followed by a share split ("split") announcement. Buybacks usually indicate that the company is confident in its position. Subsequently, it may declare that its shares are undervalued. It is not uncommon for a company to announce a buyback after its shares have fallen in price on bad news and negative analyst comments. And the latter does not necessarily mean that the company is simply trying to raise the value of its shares on the buyback news - rather, it seeks to capitalize on their cheapness.

Buybacks usually cause a decent rise in stock prices, for a variety of reasons. Obviously, lets say that if earnings are about the same level, and the number of shares outstanding decreases, then the indicator "Earnings per share" (EPS) increases. This, in turn, is often a signal to outside observers that shares are undervalued. Accordingly, the demand for shares rises, and their price rises.

Next, as the number of shares outstanding decreases, the remaining shares represent a larger percentage of the float. With growing demand and insufficient supply, the share price again rises. In addition, share buybacks are usually carried out when the company has a cash surplus. Most likely, this means that she has no problems with cash flow - and, just as importantly, her top managers apparently expect more income from investing in the company than from other investment options.

It should also be noted that when surplus cash is used for buybacks (instead of expanding the company or paying dividends), shareholders often have the opportunity to defer capital gains and reduce tax payments if the share price rises. Recall that dividends are taxed as ordinary income, and in the same year in which they are received, while income from the growth in the price of shares is taxed only when they are sold. In addition, if the shares are held for more than a year, the capital gains tax rate will be lower.

Usually, companies use market weakness (at the moment of its pullback down) in order to carry out buybacks more aggressively. This speaks to the confidence of companies in the strength of their position - and, at the same time, that they consider their shares to be too cheap. Not to mention, buybacks on the back of a dip support the share price and ultimately provide relative security for long-term investors in difficult times.

The dangers of buyback

At the same time, the buyback may be just an attempt to manipulate the share price. As mentioned above, buybacks increase EPS, one of the most important indicators used by analysts when evaluating stocks. If timed correctly, the companys EPS could exceed analysts consensus forecasts based on more shares outstanding before the buyback. So its important to keep an eye out for buyback announcements ahead of earnings reports.

Further, repurchase announcements usually do not indicate the percentage of shares to be repurchased - but only their number. Therefore, you yourself need to calculate the share of redeemable shares in order to understand whether this announcement should be given importance. Among other things, the announcement of a buyback and the actual purchase of shares are far from the same thing. The announcement may cause the share price to rise, but usually only for a short time. And then you can "forget" about the promises - it is worth noting that a considerable number of already announced buybacks are made in a significantly smaller amount than the one that was originally agreed.

Be especially careful if a buyback is announced when the share price has reached or is approaching an all-time high. It is possible that the company is trying to influence lower than it would like EPS estimates with the buyback. One way to spot such an attempt is to compare the P/E (price to earnings ratio) of a given companys stock with the P/E of other stocks in the same sector or industry. If the company you are interested in looks too high, then there is no real reason for it to buy back its shares at such a high price - and if it does, then it means that there is a banal attempt to inflate the EPS behind this.

Conclusions

Summarizing: A share price increase after a buyback announcement is usually not that significant, but it can often make sense to play on it - especially for those market participants who prefer to hold positions for a short time.