By Reuben Alberto
AS indicated in our previous article, this week we will continue to focus on share buybacks.
We are going to cons
ider the effects of a share buyback to both the investor and the company’s share. A share buyback scheme will have some significant effects on the counter. These are as follows:
*The value of the share – based on principles, the underlying value of the respective firm is reduced since the company’s net assets will have been reduced. This is so because a share buyback will result in surplus cash being used or the firm incurring more debt to finance the transaction.
On the other side, a reduction in the number of shares in issue should counterbalance this. As a result, the underlying value of each share remains almost the same.
If the company’s share price is significantly lower than the net asset value per share, (eg investment trusts often trade at a discount), the buyback should increase the value per share;
*The share price – share buy back may result in an increase on the risk level in the company. This can be explained by either the perception that there is a higher chance of defaulting on the new debt (the level of debt affects the market) or there would be difficulties in raising capital when it is needed (for cash-flow or for investment in the business). Both perceptions will most likely result in the share price being depressed.
If not properly handled, a too aggressive share buyback will result in the company pushing the share price to unsustainable levels and only to fall soon after the completion of the transaction. However, it should be noted that the price of a share is a function of supply and demand and therefore the slash inthe share price soon after a buyback may be as a result of other factors falling of a share price soon after a buyback can thus be as a result of other factors.
These may be based on the points raised above (ie perceived value) or market sentiments. The share price may also move upwards provided there are a significant number of investors who believe that the buyback had been well-handled, that the risk reward factors are relatively unchanged or have improved and that the improvement in net asset value/earnings per share is sustainable in the longer term;
*Earnings per share – after a buyback, the total company’s earnings will be divided among fewer shares. On the contrary, the total company’s earnings will have been reduced because either cash assets will be lower leading to a lower total return on interest rates or debt would have been increased so that the company pays a higher interest bill.
All things being equal, this would result in no change to the earnings per share (EPS); ie lower company earnings shared among fewer shares results in no net change to EPS. However, all things are rarely equal and earnings per share should increase in due course if cash (which has now been used for the buyback) earns a lower rate of return than the rest of the company’s activities and also if the cost per share of servicing the debt is less than the financial returns per share of using borrowed cash. Similarly the reverse would be true if the returns were lower or the cost was higher;
*Share options – share options are usually awarded to directors and employees of the company as an incentive for improving the company’s performance. They would not be part of the share buyback and as a result (because the number of shares in circulation has been reduced) the number of share options as a percentage of this new lower figure increases;
*Shareholders – the effect on the shareholders depends on the method by which shares have been bought. If shares have been bought from each shareholder (ie proportional buyback) then this may result in a capital gain and payment of a capital gains tax depends upon the circumstances that affect each shareholder.
If shares are however bought in the market, then large shareholders (usually institutional) may find their shareholding moving above a particular threshold. A share buyback may also increase control of the company to be exercised by the dominant shareholder(s), especially when they are directors and similarly the larger shareholder could find himself in a position of making an unintended takeover bid;
*Risk assessment – the risk assessment for any company is closely related to the level of cash reserves or debt and so a buyback is likely to increase the company’s level of risk. However, if a buyback is properly handled, it should also increase potential rewards for the remaining shareholders because profits and assets will be divided among fewer shares. Investors will welcome a higher level of risk only in exchange for a higher level of expected return and subject to certain limits.
As a result, good management should always ensure that the levels of risk do not go beyond what the shareholders are willing to take.
Thus, these are some of the net effects that come along with a share buyback scheme. Management should thus take into consideration most of these factors for a successful and sustainable share buyback to be pursued by the company.
In the next article we will take a look at the interest rate risk in the financial sector.
*Reuben Alberto is the general manager (investments) for Imperial Asset Management Company and can be contacted through email@example.com