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Share buybacks – what are they and how do they impact investors?

We look at the recent wave of buyback announcements and what they could mean for investors.

Important notes

This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

It seems like every time we turn around there’s a new buyback being announced. So far this year, FTSE 350 firms have announced nearly £11bn worth of buyback schemes. Compared to similar periods over the past three years, that’s a massive step upward.

Current FTSE 350 Members Buybacks Announced (£m)

Source: Refinitiv 25 March 2022.

With so many big buybacks hitting the market, it’s important to understand what they mean for investors and when they make sense for companies.

This article isn’t personal advice, if you’re unsure whether an investment is right for you, seek advice. All investments and any income they produce can fall as well as rise in value, so you could make a loss.

Understanding buybacks

Buybacks, also called share repurchases, are exactly what they sound like – it’s when a company buys back a certain proportion of its shares. They do so at the latest market price, which moves up and down, so they are usually announced as a total to be spent rather than a specific number of shares. Sometimes existing investors are given a ‘tender offer’ giving them the option to sell their shares at a premium to the current market price.

For the most part buybacks increase shareholder value. They’re a way for a company to offer additional returns to its shareholders. Because the company’s removed a number of shares from the market (or bought them back), profits will be shared out between fewer shares. Each slice of the pie is now larger.

Share buyback example

If a company has £5m in earnings and 10m shares outstanding, earnings per share (EPS) are 50p. If that company buys back 500,000 shares the new EPS would be 53p per share.

In theory, a buyback will also cause the share price to increase as well (all else being equal) – at least in the short term. That’s because, at that time, the market’s willing to pay a certain price for a company’s future earnings. Whether there are 10,000 shares or 1,000 shares, that relationship - the price-to-earnings (PE) - should hold true.

Take the above example. If shares of that company cost £10, the PE before the buyback is 20. To maintain the valuation at the new EPS figure, the share price would have to rise to £10.60 and existing shareholders would see the value of their holdings increase.

Of course, market factors are always at play in the background, so the share price reaction could be impacted by other factors as well.

Why would a company buy back shares?

There are a few reasons companies might decide to carry out a buyback.

It could be because they think their shares are undervalued. In the same way investors look for opportunities to invest in undervalued shares, companies themselves might want to buy its own shares if they believe the price doesn’t accurately reflect future prospects. In these cases, it’s seen as a nod of confidence from management. It’s also a way to reward existing shareholders who have waited out a period of slower growth.

Sometimes the decision to buy back shares is tactical. Not only does it improve shareholder value, but it also makes dividend payments more affordable. There are many companies out there whose investors expect continuous dividend growth. That means the company will need to funnel more and more cash to shareholders every year. Buying back shares when they’re undervalued reduces the cost of payments because there’ll be fewer shares to pay a dividend out on.

When to be sceptical

Not all share repurchase schemes are met with enthusiasm. Sometimes they’re seen as a negative. This can be true for growth companies that are using excess cash to repurchase shares. Investors might question whether a buyback scheme is a good use of cash if the company can earn a higher rate of return investing in its own future progress. It might signal that there aren’t any worthwhile future growth opportunities for that company.

Buybacks have also drawn criticism for artificially inflating a company’s share price. Executive compensation is often tied to share price performance, so there are some who argue that buybacks are funding big bonuses for those at the top.

When companies repurchase shares after they’ve dropped significantly, it could also put them in a precarious financial position. Stock prices haven’t tended to plummet for no reason, so a large buyback from an already struggling company will only strain finances further. It leaves behind less of a security net in case of an economic downturn or an unforeseen roadblock.

Why now?

With all of that in mind, the wave of buyback announcements we’ve seen recently makes a little more sense. The market has cooled from its 2021 highs, so companies are hoping to snap up their own shares while valuations have stabilised. Many are also looking for ways to return some of the cash they amassed during the pandemic. This is particularly true when it comes to banks, who set aside masses of capital in case of bad loans that never materialised.

What’s next?

With inflation sticking around longer than expected, companies might start to fret about the cost of their debt. Central banks are starting to tighten the purse strings, and putting an end to the era of cheap money we’ve been experiencing over the past decade. For that reason, we might start to see buybacks tail off as we move through the year.

FTSE 250 - Buybacks Completed (£m)

Source: Bloomberg 15 March 2022

Crucially, once a company announces a buyback, there’s no guarantee they’ll complete it. Some buyback schemes announced back in the 90s are still incomplete. So, while we’ve seen a wave of announcements, the number of shares purchased so far isn’t necessarily outsized.

Data from Bloomberg shows that FTSE 250 companies spent £1.8bn on buybacks between 1 January 2022 and 15 March 2022. That’s lower than what was spent in the previous two quarters.

The bottom line

Buybacks tend to get a lot of press because they’re usually a good thing for investors. But it’s important to remember they don’t say much about the underlying company. When they do, it tends to be a negative.

With that in mind, we think it’s prudent to take buyback news with a grain of salt and focus on underlying fundamentals instead. Our share research team can do a lot of the hard work for you. We cover many of the market’s most popular stocks, offering research and insight on proposed buybacks as well as a host of other topics. Get our Share Insight email delivered weekly to your inbox to stay on top of the market’s developments.

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    Important notes

    This article isn’t personal advice. If you’re not sure whether an investment is right for you please seek advice. If you choose to invest the value of your investment will rise and fall, so you could get back less than you put in.

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