Since SM has been highlighting this as its way of signaling strong confidence in the country’s economic trajectory, we thought it would be a good time to talk about share buybacks – why they are done, how they work, and what benefits they provide to shareholders.
When a company generates free cash flow from operations, it can choose to either:
1. Keep it as retained earnings to strengthen its balance sheet,
2. Use it as capex to expand its business,
3. Use it to acquire a new business unit,
4. Give it back to shareholders in the form of dividends, or
5. Use it to buy back shares through a tender offer or on the open market.
The first three options are typically viewed as the company reinvesting its earnings to strengthen its position for the long term, while the last two options are a way of improving value for shareholders.
A safety net to catch you if you fall
The first and most obvious effect of a share buyback is that it alters the demand-supply dynamics for the company’s shares. In a way, it sort of provides a safety net for shareholders in the event of a market downturn, as the company can step in to absorb the selling pressure and prevent the price from falling too far.
A confidence boost
Aside from providing additional demand for shares, share buybacks also provide an immediate boost to investor confidence. It sends the message that the company is willing to spend money to prove that it thinks its stock is already undervalued.
In short, it is a way for a company to put its money where its mouth is. On a more speculative note, a share buyback is sometimes the company’s way of reducing its public float and signaling its intent to go private.
A bigger slice for everyone
Even though we say that the company is putting its money where its mouth is, note that the company does not become a shareholder of itself when it buys back shares, and it does not get capital gains when the stock’s price goes up.
When shares are bought back, they are taken out of circulation and are no longer considered outstanding shares. Instead, they become part of the company’s treasury shares, which can either be retired or re-issued as stock options for employees or as shares for a new strategic investor in the company. (Interesting side note:
This is how ICT utilizes its share buyback program to offset the dilutive effect of its employee stock option program.)
Since these shares are no longer considered outstanding, share buybacks have the effect of boosting per-share metrics, like earnings per share and dividends per share.
However, it must be noted that the company will have to buy back a significant number of shares to make this effect noticeable.
A shortcut to better returns
Aside from boosting per-share metrics, share buybacks also have the effect of improving return metrics like ROA (return on assets) and ROE (return on equity).
Remember that when a company buys back shares, it uses up cash. This reduces the Assets side of the balance sheet (under cash & cash equivalents) and the Equity side of the balance sheet (since treasury shares are a negative entry on equity).
If a company buys back a significant number of shares, it lowers the divisor for the computation of ROA and ROE, which gives the impression of improving returns even if net income growth slows down.
Buying back is giving back
Critics of share buybacks often argue that company resources are best used to expand the business, or to directly reward shareholders in the form of dividends, rather than try to influence share prices or valuation metrics.
They often equate supporting prices using share buybacks to price manipulation and argue that implementing a share buyback for this purpose is short-sighted and a waste of corporate earnings.
However, we are of the opinion that it should not be a problem if the company does not actively try to influence the share price or prevent proper price discovery.
Further, we believe that share buybacks are a legitimate way to return value to shareholders that can have positive long-term implications. At the very least, it is a better use of resources than expanding for expansion’s sake or acquiring a new venture that does not synergize well with the existing business.
Financial market recommendations and comments on InsiderPH News belong solely to the analysts and institutions making them. They do not represent buy, sell or hold recommendations of InsiderPH News. Investments held by analysts or institutions may influence their recommendations. Investors should conduct their own research and carefully evaluate all relevant market information before making investment decisions. As always, the past performance of any investment does not guarantee its price appreciation in the future.
