Under a stock repurchase plan
, a firm buys back some of its outstanding stock, thereby decreasing the number of shares, which should increase both EPS and the stock price. Unlike stock dividends and stock splits, share repurchases use corporate cash. This is an alternative way of paying cash dividends.
Shares that have been issued and subsequently repurchased become treasury shares
, which are not considered for dividends, voting, or computing earnings per share.
Reasons for Share Repurchase
There are different reasons for share repurchases:
- Repurchase announcements are viewed as positive signals by investors because the repurchase is often motivated by management's belief that the firm's shares are undervalued. There is no question that the company has more information about itself than does any other entity; it is therefore the ultimate insider.
- A company can remove a large block of stock that is overhanging the market and keeping the price per share down.
- If the excess cash is thought to be only temporary, management may prefer to make the distribution in the form of a share repurchase rather than declare an increased cash dividend which cannot be maintained.
- Companies can use the residual model to set a target cash distribution level, then divide the distribution into a dividend component and a repurchase component. The company has more flexibility in adjusting the total distribution than it would if the entire distribution were in the form of cash dividends.
- In some countries the tax rate on capital gains is lower than that on cash dividends.
- Repurchases can be used to produce large-scale changes in capital structures. For example, if a firm's capital structure is too heavily weighted with equity, it can sell debt and use the proceeds to buy back stocks, thus increasing the debt ratio.
The disadvantages are:
- Stockholders may not be indifferent about dividends and capital gains (e.g., different tax treatments), and the price of the stock might benefit more from cash dividends than from repurchases.
- Repurchases normally occur in the greatest number when times are good and companies have lots of cash and, concurrently, when share prices are relatively high. The corporation may pay too high a price for the repurchased stock, to the disadvantage of remaining stockholders.
The four most important methods are:
- Open market repurchases through a designated broker. This is the most common method of repurchase, often used to support the share price.
- Fixed-price tender offers. Usually there is a premium offered to induce shareholders to sell. If management thinks the stock is undervalued, it is willing to pay a premium.
- Dutch auction. A Dutch auction specifies a price range within which the shares will ultimately be purchased. Shareholders are invited to tender their stock at any price within the stated range. The purchase price is the lowest price that allows the firm to buy the number of shares sought in the offer, and the firm pays that price to all investors who tendered at or below that price.
- Direct negotiation with major shareholders. Shares are often acquired at a premium to the market price. One purpose is to prevent raiders from acquiring company at an attractive price.