The paramount objective of investment is profit, and the imperative for return on investment is no more relevant than when you have invested in a company and the company has declared a profit. The management of the company is however faced with the vexing question of determining whether to apply the profits towards issuing dividends to shareholders or to embark upon a stock buyback programme. Companies which retain substantial amounts of cash on their balance sheet make attractive targets for takeover, especially as they imply that the management of the company are incapable of effectively applying the retained earnings towards the generation of further profits for the company.
When a company repurchases its shares, it reduces the number of shares held by the public, thereby increasing the company’s subsequent earnings per share. This in turn increases the value of the outstanding shares. This option best obtains where the shares of the company are undervalued and shareholders are relatively unsophisticated. The repurchased shares may later be resold to new investors at a substantial profit to the company.
The repurchase programme has the added advantage of making the outstanding shares more expensive, reducing the attractiveness of the company as a takeover target. Moreover, buybacks reduce the assets on the balance sheet, thus increasing the company’s return on assets and return on equity without any substantial increase in the performance of the company. This cosmetic effect often impresses positively on the investment community, especially investment analysts and retail investors.
A further benefit of stock buybacks is the reduction of shareholder tax liability, making it a tax efficient form of earnings distribution. When a company makes a profit, it is statutorily obligated to pay Companies Income Tax on its profits before dividends are issued. Upon the issuance of dividends, the shareholder pays the government a withholding tax, meaning that the profits have been subjected to double taxation. Stock buybacks thus rewards the shareholder financially, without the tax liabilities inherent in dividend issuance.
Typically, buybacks are carried out in one of two ways:
- Tender Offer:
the company may present the company with an offer to submit, or tender, a portion or all of their shares within a certain time frame. The tender offer will stipulate both the company is looking to repurchase and price they are willing to pay, which is almost always at a premium to the market price of the shares. Shareholders who accept the offer will state the number of shares they intend to tender and the price which they are willing to accept. Once the company has received all the offers, it will find the right mix to buy the right mix to buy the shares at the lowest cost.
A variant of the tender offer is the fixed price tender offer. Whereby the company stipulates a price at which it is willing to repurchase the shares and gives the shareholders the option to accept the offer as stated. This is the method currently utilized by Unilever Plc in its recently concluded tender offer.
- Open Market Buyback:
This involves the purchase of the shares by the company on the open market in a manner similar to open market transactions commonly undertaken by any other party. It is important to note, however that the Investment and Securities Act (2012) requires companies to announce the commencement of a stock buyback scheme and the announcement of a buyback commonly results in a rise in the share price of the company.
There is no definite answer to the question as to whether stock buybacks are a beneficial option, as this depends upon the circumstances surrounding the tender offer.
Milton and Cross offers investment advisory and due diligence services to individual and corporate shareholders who require legal advice on the issuance or acceptance of tender offers and the elements of share repurchase transactions generally. We may be contacted directly on +2348036258312, or by email on : email@example.com