The same goes for kpis such as return on equity, which look better than before when a company buys back its own shares. Many early share certificates bore an image – a factory, a car, a channel – that represented the purpose of the company they had issued. It reminded us that the financial instrument was being used productively. Companies that put their profits into buyouts would have a hard time putting an image on their share certificate today, except perhaps the face of their CEO. When companies have excess capital and growth opportunities are low, a share buyback can be a wise financial decision. The tricky part is making sure managers and CEOs focus on sustainable, long-term growth, rather than driving stock prices at the expense of their shareholders (and lining their pockets). In addition, short-term investors often try to make money quickly by investing in a business that leads to a planned buyout. The rapid influx of investors artificially drives up the stock`s valuation and increases the company`s price-to-earnings (P/E) ratio. Return on equity (ROE) is another important financial measure that is automatically increased. On the other hand, there is sometimes unfavorable news or a change in the market while the company is in the process of buying its own shares. In this case, the shares could trade down for some time, even if the total number of outstanding shares has been reduced by the buyback. And then there`s Merck.
The pharmaceutical company was an excellent example of corporate excellence in the second half of the 20th century. „Medicine is for people, not for profit,” George Merck II said on the cover of Time in 1952. „And if we remembered it, the profits never stopped.” In the late 1980s, then-CEO Roy Vagelos, instead of sitting on a drug that could cure river blindness in Africa but for which no one could pay, convinced his board of directors to produce and distribute the drug for free – which, as Vagelos later noted in his memoirs, cost the company more than $200 million. More recently, Merck used its huge profits (net profit for 2018 was $6.2 billion) to buy back its own shares. A study by economists William Lazonick and Öner Tulum showed that from 2008 to 2017, the company distributed 133 percent of its profits to shareholders through buybacks and dividends — including CEO Kenneth Frazier, who has sold $54.8 million worth of shares since July last year. How is it sustainable? „That`s not the case,” Lazonick says. Merck insists it needs to keep drug prices high to fund new research. In 2018, the company spent $10 billion on research and development – and $14 billion on share buybacks and dividends. The reality is that many companies choose share buybacks as the main (and only) approach to returning profits to investors. So why exactly do companies buy back their own shares when they could simply pay dividends directly to their shareholders instead? In the following, we briefly discuss three valid reasons why companies buy back shares.
Share buybacks are an alternative to dividends. When a company buys back its own shares, it reduces the number of shares held by the public. The reduction in the free float or publicly traded shares means that even if earnings remain the same, earnings per share will increase. Share buybacks when a company`s stock price is undervalued benefits non-selling shareholders (often insiders) and derives value from selling shareholders. There is strong evidence that companies are able to buy back shares profitably if the company is owned by retail investors who are less demanding (for example. B, retail investors) and are more likely to sell their shares to the company if those shares are undervalued. If, on the other hand, the company is mainly owned by more sophisticated insiders and institutional investors, it is more difficult for companies to buy back shares profitably. Companies can also buy back shares more easily at a profit if the stock is trading liquid and the companies` business is less likely to move the share price. Share buybacks refer to the repurchase of shares by the company that issued them. A buyback occurs when the issuing company pays shareholders the market value per share and takes back the portion of its property that was previously distributed to public and private investors. In most countries, a company can buy back its own shares by distributing cash to existing shareholders in exchange for a fraction of the company`s outstanding equity; That is, the money is exchanged for a reduction in the number of shares outstanding. The company withdraws the repurchased shares or keeps them ready to be reissued as own shares.
Since investors generally assume that a company`s management should know what it is doing, share buybacks often cause positive reactions among investors, as it suggests that the company believes the shares are currently trading at an undervalued price. .