SHARE BUY BACK BY ADAMA UMARU.

ADAMA UMARU ON RECENT SHARE BUYBACK ACTIVITY ON NGX
Stock buybacks refer to the repurchasing of shares of stock by the company
that issued them. A buyback occurs when the issuing company pays
shareholders the market value per share and re-absorbs that portion of its
ownership that was previously distributed among public and
private investors.
With stock buybacks, aka share buybacks, the company can purchase
the stock on the open market or from its shareholders directly. In recent
decades, share buybacks have overtaken dividends as a preferred way to
return cash to shareholders. Though smaller companies may choose to
exercise buybacks, blue-chip companies are much more likely to do so
because of the cost involved.
KEY TAKEAWAYS
• Companies do buybacks for various reasons, including company
consolidation, equity value increase, and to look more financially
attractive.
• The downside to buybacks is they are typically financed with debt,
which can strain cash flow.
• Stock buybacks can have a mildly positive effect on the economy overall.
Reasons for Buybacks
Since companies raise equity capital through the sale of common
and preferred shares, it may seem counter-intuitive that a business might
choose to give that money back. However, there are numerous reasons why it
may be beneficial to a company to repurchase its shares, including
ownership consolidation, undervaluation, and boosting its key financial ratios.
Unused Cash Is Costly
Each share of common stock represents a small stake in the ownership of the
issuing company, including the right to vote on the company policy and
financial decisions. If a business has a managing owner and one million
shareholders, it actually has 1,000,001 owners. Companies issue shares to
raise equity capital to fund expansion, but if there are no potential growth
opportunities in sight, holding on to all that unused equity funding means
sharing ownership for no good reason.Businesses that have expanded to dominate their industries, for example, may
find that there is little more growth to be had. With so little headroom left to
grow into, carrying large amounts of equity capital on the balance sheet
becomes more of a burden than a blessing.
Shareholders demand returns on their investments in the form of dividends
which is a cost of equity—so the business is essentially paying for the
privilege of accessing funds it isn’t using. Buying back some or all of
the outstanding shares can be a simple way to pay off investors and reduce
the overall cost of capital. For this reason, Walt Disney (DIS) reduced its
number of outstanding shares in the market by buying back 73.8 million
shares, collectively valued at $7.5 billion, back in 2016
Preserves the Stock Price
Shareholders usually want a steady stream of increasing dividends from the
company. And one of the goals of company executives is to maximize
shareholder wealth. However, company executives must balance appeasing
shareholders with staying nimble if the economy dips into a recession.
Why are buybacks favored over dividends? If the economy slows or falls into
recession, the company might be forced to cut its dividend to preserve cash.
The result would undoubtedly lead to a sell-off in the stock. However, if the
company decided to buy back fewer shares, achieving the same preservation
of capital as a dividend cut, the stock price would likely take less of a hit.
Committing to dividend payouts with steady increases will certainly drive a
company’s stock higher, but the dividend strategy can be a double-edged
sword for a company. In the event of a recession, share buybacks can be
decreased more easily than dividends, with a far less negative impact on the
stock price.
The Stock Is Undervalued
Another major motive for businesses to do buybacks: They genuinely feel
their shares are undervalued. Undervaluation occurs for a number of reasons,
often due to investors’ inability to see past a business’ shortterm performance, sensationalist news items or a general bearish sentiment.
If a stock is dramatically undervalued, the issuing company can repurchase
some of its shares at this reduced price and then re-issue them once the
market has corrected, thereby increasing its equity capital without issuing any
additional shares. Though it can be a risky move in the event that prices stay low, this maneuver can enable businesses that still have long-term need
of capital financing to increase their equity without further diluting company
ownership.
For example, let’s assume a company issues 100,000 shares at N25 per share,
raising N2.5 million in equity. An ill-timed news item questioning the
company’s leadership ethics causes panicked shareholders to begin to sell,
driving the price down to N15 per share. The company decides to repurchase
50,000 shares at N15 per share for a total outlay of N750,000 and wait out the
frenzy. The business remains profitable and launches a new and
exciting product line the following quarter, driving the price up past the
original offering price to N35 per share. After regaining its popularity, the
company reissues the 50,000 shares at the new market price for a total capital
influx of N1.75 million. Because of the brief undervaluation of its stock, the
company was able to turn N2.5 million in equity into N3.5 million without
further diluting ownership by issuing additional shares.
It’s a Quick Fix for the Financial Statement
Buying back stock can also be an easy way to make a business look more
attractive to investors. By reducing the number of outstanding shares, a
company’s earnings per share (EPS) ratio is automatically increased – because
its annual earnings are now divided by a lower number of outstanding shares.
For example, a company that earns N10 million in a year with 100,000
outstanding shares has an EPS of N100. If it repurchases 10,000 of those
shares, reducing its total outstanding shares to 90,000, its EPS increases to
N111.11 without any actual increase in earnings.
Also, short-term investors often look to make quick money by investing in a
company leading up to a scheduled buyback. The rapid influx of investors
artificially inflates the stock’s valuation and boosts the company’s price to
earnings ratio (P/E). The return on equity (ROE) ratio is another important
financial metric that receives an automatic boost.
One interpretation of a buyback is that the company is financially healthy and
no longer needs excess equity funding. It can also be viewed by the market
that management has enough confidence in the company to reinvest in itself.
Share buybacks are generally seen as less risky than investing in research and
development for new technology or acquiring a competitor; it’s a profitable
action, as long as the company continues to grow. Investors typically see share buybacks as a positive sign for appreciation in the future. As a result, share
buybacks can lead to a rush of investors buying the stock.
Downside of Buybacks
A stock buyback affects a company’s credit rating if it has to borrow money to
repurchase the shares. Many companies finance stock buybacks because the
loan interest is tax-deductible. However, debt obligations drain cash reserves,
which are frequently needed when economic winds shift against a company.
For this reason, credit reporting agencies view such-financed stock buybacks
in a negative light: They do not see boosting EPS or capitalizing on
undervalued shares as a good justification for taking on debt. A downgrade in
credit rating often follows such a maneuver.
Effect on the Economy
Despite the above, buybacks can be good for a company’s economics. How
about the economy as a whole? Stock buybacks can have a mildly positive
effect on the economy overall. They tend to have a much more direct and
positive effect on the financial economy, as they lead to rising stock prices.
But in many ways, the financial economy feeds into the real economy and vice
versa. Research has shown that increases in the stock market have an
ameliorative effect on consumer confidence, consumption and major
purchases, a phenomenon dubbed “the wealth effect.”
Another way improvements in the financial economy impact the real economy
is through lower borrowing costs for corporations. In turn, these corporations
are more likely to expand operations or spend on research and development.
These activities lead to increased hiring and income. For individuals,
improvements in the household balance sheet enhance chances they leverage
up to borrow to buy a house or start a business.
DANGOTE CEMENT PLC EXAMPLE
It is the first shares repurchase to be launched in Nigeria as investors and
regulators alike have long harboured fears that the process could be abused.
Section 161 of the Corporate and Allied Matters Act lays out the process for a
company to execute an SBB, also Rule 398 (3)(xiv) of the Securities and
Exchange Commission’s Rules and Regulations with Rule 13.18 of the Rulebook of The Nigerian Stock Exchange gives Regulatory backing to this
action
Dangote Cement Plc, Nigeria’s most capitalised company, initiated the
repurchase of 10 per cent of its 17.041 billion ordinary shares December 2020
in order to scale up the long term shareholder value.
It will serve also as “a valuable tool for managing capital structure and balance
sheet efficiency” and a “window to return cash to shareholders,” according to
the programme explanatory statement.
The decision “reflects that the management believes in the valuation and
prospects of the company.
The first tranche saw the acquisition of 0.24 per cent of its issued and fully
paid common stock even though management had proposed to buy back 0.5
per cent for a start.
That transaction cost the cement-maker more than N9.769 billion to
consummate at a unit price of N243.02. As of the end of third quarter 2020,
Dangote Cement held cash and cash equivalent of N176.653 billion ($449.9
million) on its books, providing the money it needed to splurge on buyback
deals.
The shares to be bought back will be held as treasury shares and could be
cancelled when the transaction is over. Shares in the company were up by 10
per cent the very day it announced repurchase plans.
“Share buyback programs can be great for shareholders because following the
share repurchase, shareholders will own bigger portions of the company, and
therefore bigger portions of the said company’s cash flow and earnings
“Management will pursue share buybacks because they offer the greatest
potential return for shareholders. If a company with the potential to use cash
to pursue operational expansion chooses instead to repurchase its stock, then
it could be a sign that the shares are undervalued. The signal is even stronger
if company executives are buying up (additional) stock for themselves,” Low-risk use of extra cash
Yet, some analysts have railed against share repurchase, holding the view that
companies utilizing their excess cash for such purposes will be diverting more
money from other critical investments like innovation, building new factories,
creating more jobs and increasing staff wages.
That retreat from bold investments, they believe, is aimed at gaming stock
markets and artificially driving stock prices up, a move seen as mostly
favoring corporate executives, whose wealth is often linked to equity
ownership in their firms.
A share repurchase may demonstrate to investors that the company lacks
profitable opportunities for expansion, potentially putting off growth
investors seeking revenue and profit increases.
Yet, its appeal has not waned among corporates around the world,
particularly as regards its potential to offer reasonably low-risk approaches
for companies to deploy extra cash.
Reinvesting cash into R&D or a new product can be risky. If those investments
fail, that hard-earned cash goes down the drain. In contrast, share repurchase
programs grant corporations an opportunity to invest in themselves when
they believe their stocks are undervalued and offer a good return for
shareholders,
Impact on market
It remains unclear, however, how much buybacks could support market gains.
It (buyback) is a largely common event when the equities market is
experiencing an upswing. And as we know, the Dangote Cement share
buyback programme was executed at a time when the Nigerian stock market
was on a bullish run. Would it therefore be appropriate for companies to
pursue buybacks during economic slowdowns like now?
“That said, it should be noted that improved stock market performance is
usually underpinned by better economic fundamentals, which makes the
performance of the equities markets in 2020/21 an anomaly, seeing as it was
largely driven by the low interest rate environment and increased liquidity in
the financial markets due to limited investment options.”It should be observed that share repurchase schemes are capable of depriving
companies the liquidity needed as a buffer against hard times such as a
moment of sales and profit decline during a downturn.
Also it is notable to observe that moves by companies without substantial
cash reserves wanting to execute share buybacks with proceeds of additional
debt run contrary to financial wisdom as they will be heading for troubles
right ahead.
“It is a form of financial risk-taking that can considerably weaken a
corporation’s credit quality. Also, it can bring about an unduly leveraged
balance sheet, leaving the company exposed to economic shocks.”
More companies listed on the Nigerian Stock Exchange are not likely to go the
way of share repurchase, considering that there are only a handful of firms in
the country with the level of retained cash to do buybacks like Dangote
Cement, predictably.
“It is intriguing that post-share buyback, the valuation of a company becomes
cheaper, making it attractive to potential shareholders and investors to bid up
the share price. This will create additional value for existing shareholders,”
The key point to note in this regard is that the number of issued shares
reduces, making the earnings per share rising to reflect a cheaper price-toearnings ratio. Share buyback is also constructive in the sense that future
dividend per share is stronger, particularly when the profit after tax is rising.”
Stock buybacks announced in corporate America surpassed $1 trillion in
2018 alone, a figure reckoned by analysts to outweigh the value of a
Facebook or an ExxonMobil. Apple accounted for $100 billion of that sum
with heavyweights like Microsoft, Wells Fargo, Oracle and Merk in tow.
The figure approached $730 billion in 2019 and, despite the pandemic
outbreak last year, Harvard Business Review research estimated that more
than half of corporate profits in the United States go towards share buybacks,
an affirmation of the stark faith Americans have in repurchase schemes to
turn the corner for stocks that are priced low

About the Author

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First Ideas Limited is an investment and financial advisory company established in 1994 to provide advisory services to high net worth individuals, trust funds, financial institutions and medium sized companies in growth sectors.

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