Share buy backs: What they are and how they work

31st August 2011

The Aussie brewer has said it may buy back its own shares to prevent SAB from acquiring them.

But less spectacularly, share buybacks are around most of the time and across many major markets.

Over the summer, pharmaceutical group AstraZeneca and defence giant BAE were among UK firms taking the buyback route. So what are they? And do they work?

At a basic level, buybacks are the reverse of the "rights issue" where a company issues new shares to investors to gain cash, at a discount to the price prevailing at the time.

A company with one billion shares currently at 100p each might wish to raise £90m, for example. It can do this by offering each shareholder the right to buy one new share for each ten already held but at a discounted 90p.

The buyback turns this on its head. Here a company with spare balance sheet cash (or occasionally the option to borrow ) sends its brokers into the market to buy up shares at a premium to the current price.

These shares will then usually be cancelled ( or sometimes held "in treasury" so they can be re-issued at a later date). But unlike a rights issue which involves a relatively short time frame, buybacks are usually employed over long periods

Proponents say the effect is beneficial both to shareholders and to companies.

A company which has total earnings to distribute of £1billion, for example, would have earnings per share of 10p if it had 10 billion shares but of 20p if the number of shares in issue was cut to five billion with a buyback.

In practice, the proportion of shares bought in is not so large – this is just a simplified example.

Higher earnings should result in an enhanced share price, more than compensating remaining shareholders for the loss of the cash in the balance sheet.

At the same time, money available for dividends can be divided among a smaller number of shares so the payout can be higher – again giving a potential boost to the share price.

A higher rating is positive while, directors say, hoarding cash is pointless when it can be better used by shareholders elsewhere.

But as with all forms of financial engineering, the buyback is controversial. On the plus side, funds investing in major stocks such as AstraZeneca and BAE have had a boost over the summer. BAE announced a £500m scheme while AstraZeneca has been buying in shares since mid 2010.

On the minus side, some commentators suggest buybacks destroy value in the long run because giving money back to shareholders suggests that the managers have no long term plans to use the cash available to expand the business.

Some see a buyback as a window to sell shares whose long term value they regard as dubious. Those against the practice also say firms tend to buy in at the wrong time and so pay too much – Société Générale research on US companies showed that more than half of S&P 500 company boards sanctioned buybacks at the peak of the market during 2007-08, while fewer than a quarter did so during market troughs.

Buybacks have been commonly used in investment trusts since the practice was first permitted in 1999.

Some trusts have long running programmes where they buy in their own shares when the discount to the underlying net assets goes above a target number – perhaps 10 per cent.

By reducing the shares, the net asset value increases on the remainder, which should push up the price.

They often put the shares into treasury where they can be re-issued later on when the discount falls or perhaps becomes a premium.

But fixed targets – and other facets of buybacks – have their critics.

They say this policy can be inflexible and lead to unwise sales of key portfolio items. Critics also say investment trust managers are paid to invest money for savers – not to give it back.

Kevin Murphy, co-manager of the £1.2bn Schroder Income fund which has a large AstraZeneca weighting, said:

"The casual reader of the financial pages may gain the impression share buybacks are universally bad but of course it is rarely so black and white. There is nothing fundamentally wrong or value-destroying about share buybacks.

"They are a valid tool by which companies can increase shareholder value – with one important caveat. The shares must be repurchased when they stand at a discount to their intrinsic value – something not every company manages to achieve."

He believes buybacks can create value for shareholders when used at the right time.

He said: "Housebuilders, some general retailers and certain media companies could benefit from buybacks but many of them don't want to take that balance-sheet risk when the current outlook is so uncertain.

But he added "The growth shareholders find important is earnings per share rather than top-line profits, and companies can grow EPS without growing profits (through buybacks)."


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