Why Would a Firm Repurchase Its Own Stock?
During the onset of the U.S. financial crisis of 2008, the federal government stepped in to "bail out" many large, publicly traded corporations that were facing bankruptcy. Recently, news outlets have run stories on how many of these same businesses are now using excess funds to repurchase stock rather than hire new employees. Although issuing stock is an excellent vehicle for raising capital, repurchasing stock can be an equally valuable business tactic.
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Managing Cash Flow
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Before a share buyback can occur, the business needs an unusual excess of cash on its balance sheet. While the business could simply leave the surplus in the bank, the cash's value would be significantly eroded by taxes and inflation. To protect its surplus, the business could invest it in new physical capital (e.g., factories, machines, vehicles) or acquire new assets. Alternately, the business could return its surplus back to its shareholders, either through issuing dividends or repurchasing stock.
Dividends vs. Buybacks
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A stock dividend is a payment made to shareholders based on the number of shares held. For example, if company "XYZ" has a surplus of $15,000,000 and 150,000,000 shares outstanding, it could convert the surplus into a $0.10 dividend per share. Thus, a person who owns 10,000 shares of XYZ stock would be sent a check for $1,000.
In a buyback scenario, company XYZ would use its $15 million surplus to purchase a few million shares of its own stock, which would reduce the total number of shares available on the open market.
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Improving Financial Ratios
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When comparing stocks, prospective investors examine several financial ratios on each company's balance sheet. Three of the most important ratios--return on assets (ROA), return on equity (ROE) and earnings per share (EPS)---are influenced directly by a stock buyback. Reducing surplus cash (via a buyback) reduces the company's total assets, which increases ROA. Reducing the number of shares (and the equity they represent) increases EPS and ROE, respectively. Taken together, these improved financial ratios can make the stock more attractive, thus increasing the share price.
Counterbalancing Employee Stock Options
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Instead of paying higher salaries, a company may compensate employees by offering stock. While this helps curb payroll expenses in the short run, issuing stock (i.e., equity) in the company for free effectively dilutes the value of existing shares. Furthermore, increasing the number of shares outstanding hurts EPS and ROE, making the stock less attractive and lowering its market price. A buyback would specifically remedy the problem of share dilution.
Thwarting a Hostile Takeover
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If a company feels that it is in danger of a hostile takeover, a buyback is a possible defensive maneuver. Because a hostile takeover requires that the aggressing party control at least 51 percent of shares outstanding, a buyback could either allow the company to achieve 51 percent ownership first (thus precluding the takeover) or make the takeover more difficult by increasing the stock price.
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References
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