The Benefit of Share Buybacks
By PAIP Canada staff
“Company ABC is going to increase its dividend.”
When we hear that a company is going to increase its dividend, it usually translates to a positive sentiment. It makes shareholders happy as it increases their financial rewards. It also signals that the company either has increasing profits or a lack of new investment opportunities to deploy their capital.
Should a company have excess capital, there are two choices: invest it in a new initiative (meaning spend it), or return it to shareholders (meaning to save it, but in someone else’s pocket).
When the decision to return capital to shareholders is made, there are two ways of doing it: the first is to pay a dividend, and the second is to undertake a share buyback.
The payment of a dividend is fairly straightforward, but the undertaking of a share buyback is not. The purpose of a share buyback is to take the excess capital (sitting in a company’s bank account) and spend it on the company’s own shares. Once the company owns the shares, then they can be “retired” which means taken out of circulation.
As an example, if a company with 1,000 shares were to repurchase 100 shares, then only 900 shares would remain in circulation. Doing this has many effects on a company and its shareholders.
First, if the share price remains stagnant, then the total value of the company would decrease, but this is rarely the case. In most cases, fewer shares outstanding translates to a higher share price, as each share is entitled to a larger portion of the profits.
When there were 1,000 shares outstanding and the company earned $1,000, then the earnings per share were $1. Following a share buyback which reduces the total number of shares to 900, the earnings per share would become $1.11. Assuming the same price to earnings multiple, the share price would increase, even if total earnings don’t.
The second advantage of a share buyback is the existing dividend becomes less costly to pay. If the dividend was $0.20 per share, then the total cost of the dividend just declined from $200 to $180. The $20 that was “saved” could then be used to repurchase additional shares.
Sometimes these things snowball. The question investors need to ask themselves is how they can get in the way of the snowball.