Share buy backs may be seen as a positive move by the market. This is because it looks as though the company is confident of their stock price going up. But these share buy backs may indicate the company is not using their capital efficiency. Below are some hidden negatives of share buy backs.
What is a share buy back?
Share buybacks occur when a company repurchases their own shares so they can gain back some ownership from shareholders. They do this by offering shareholders the market price for their shares.
Negatives of a buy back
- Share buybacks use cash from the company which could otherwise be used to expand the business or implementing new products. Investors should ask whether this was the best thing for the company and shareholders.
- Share buybacks may also cause dividends to be reduced or cut off completely. If a company uses its cash reserves to buy back its own shares, there may not be enough surplus cash to pay dividends to shareholders.
- Share buy backs may improve financial ratios due to the reduction in outstanding shares but there may not have been any increase in earnings. For instance, one ratio which can be improved with reduced outstanding shares is earnings per share (EPS). This ratio demonstrates how much profit is distributed to each outstanding share. Therefore, if there are less outstanding shares, then each shareholder receives more profit per share. Because the price per earnings ratio (market price per share/earnings per share) uses the EPS value, then this ratio is also affected by buybacks. When the EPS value is higher, then the price per earnings for the company is lower although there was no increase in earnings for the company. This can make the company look cheaper with a lower P/E multiple.
- Share buy backs may cause a temporary increase in the share price as the market may see the confidence of companies participating in the buy back as a positive transaction. Buybacks may also cause a share price appreciation as there are less shares trading in the market. However, once investors see that the buyback may have altered the financial ratios positively but there has been no change in earnings, then we may see a share price depreciation.
- Company executives may use share buy backs to artificially boost up the share price in the short term and then sell their shares at a higher price.
- Companies may participate in share buy backs when the stock is overvalued which doesn’t illustrate good use of capital.
Lauren Hua is a private client adviser at Fairmont Equities.
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