How do you participate in the share buyback
Share buyback - explanation & reasons
Author: Pit Wilkens
As part of a share buyback, also known as “share buyback”, “buyback” or “stock repurchase”, a stock corporation buys back its own shares with available funds. The consequence is, among other things, a reduced number of shares in circulation (free float), which can lead to rising prices. In principle, the share buyback is a way of returning financial resources to the shareholders.
Share buyback definition
The share buyback describes a process in which a company buys back its own shares. This is possible both via stock exchange trading and in the form of a sale offer (so-called tender procedure) to the shareholders. Such an offer is usually made at a rate above the current daily rate.
How are share buybacks funded?
After a company has decided to buy back its own shares, it can acquire them as a participant in regular stock exchange trading. Usually, share buyback programs are designed for a period of time. This is to prevent the share price from rising due to increased demand from the company itself and the share buyback becoming more expensive. As an alternative to buying back shares on the stock exchange, the tender process is a way of buying back shares.
Shares that a company repurchases itself have no voting rights in company ownership and no right to a share of the profits in the form of dividend payments. As a result, the share buyback increases the dividend and the proportion of voting rights per remaining share.
A company can finance the buybacks from equity or debt. When using equity capital, liquid funds can be used. Alternatively, it is also possible to sell financial assets, for example. In times of low interest rates in particular, the use of debt capital for share buybacks can also be an option.
Fundamental for a positive effect of this construct is the fact that the interest on borrowed capital to be paid is below the dividend rate. Then the company would save itself more dividend payments than it has to pay interest on borrowed capital. This can increase a company's liquidity. A debt-financed share buyback also bears the name "Leverage Buy Back" based on the leverage effect.
Note: Share buybacks based on leverage tend to increase a company's risk. For example, increases in interest rates or falling corporate profits can reverse the positive effect of the leverage effect. In addition, the equity ratio of a company is falling due to the increasing debt. This can result in a poor credit rating or poorer financing terms.
Procedure in Germany
Up to 1998 the acquisition of own shares was only possible to a limited extent and only permitted in exceptional cases. This included, for example, passing on the shares to employees of the company. The Control and Transparency Act (KonTraG) laid the foundation for more extensive share buybacks. Pursuant to Section 71 of the Stock Corporation Act in its new version, a company can, with a resolution of the general meeting, acquire up to ten percent of the share capital over a period of five years as part of share buybacks.
The share capital is to be understood as the amount that was paid in when the company was founded. Over time, the share capital can be increased, for example, through capital increases.
After the authorization of the general meeting, a report must be made to BaFin (Federal Financial Supervisory Authority). If the Management Board's authorization is actually implemented in the form of share buybacks, the company must publish this in an ad hoc announcement. After purchasing own shares, these must be accounted for in accordance with the applicable accounting standards.
Note: The legal limit for share buybacks is based on the history of this instrument. In many cases, companies have used share buybacks to give preference to some shareholders despite the threat of bankruptcy and to give them the opportunity to sell their shares at comparatively high prices. This approach can harm both creditors and the remaining shareholders.
For the first time, share buybacks played an important role in the USA in the 1980s. Since then, the level of use of this instrument has increased significantly. Since the turn of the millennium, share buyback programs have also been used increasingly in Europe. Often these are limited to the leading indices of the respective countries. As a result, share buybacks have mainly been carried out by large companies.
Reasons for a share buyback
A company can achieve different goals with share buybacks and consequently has different reasons for doing share buybacks. Some of these goals can be combined with each other or are mutually dependent.
Use of excess liquidity
If a company has liquid funds that it will not be able to use profitably in the foreseeable future, it has various options for action. The money can stay with the company, be distributed as dividends or used for share buybacks. From a shareholders' point of view, keeping the money in the company is comparatively unattractive if the management has no plans for investing it. In many countries, taxes are levied on dividend payments, which can be avoided by buying back shares. As a result, there may be a tax deferral effect for shareholders despite capital repatriation, provided they continue to hold the shares.
Protection against hostile takeovers
A hostile takeover refers to acquisition projects that address the owners (shareholders) of a company directly without first having reached an agreement with the company bodies (e.g. management board and supervisory board). In the course of the takeover, however, an agreement is also possible at a later date.
The aim of the acquirer of a company is to bring the majority of the company shares into his possession. The effort required for this depends on the shareholder structure, the share price and the number of tradable shares. The more concentrated the shareholdings of the shareholders, the more difficult a takeover tends to be. For example, if a single shareholder holds 51% of all voting shares, a takeover is no longer possible.
Note: Whether and to what extent share buybacks actually protect against hostile takeovers can only be assessed individually in practice. If the share price falls despite a reduction in the tradable shares, this would actually make a takeover easier. If there are already prospective buyers among the shareholders, this also makes their project easier instead of making it more difficult. From an investor's point of view, the question must also be asked whether it is actually detrimental to the company's value if the ownership structure changes. A takeover can therefore also be an advantage.
Own shares as acquisition currency
When a company is taken over, shares bought back can serve as part of the purchase price payment. For example, if a company does not have enough cash reserves to buy a takeover candidate, it can finance the takeover with a mixture of cash and its own shares. This procedure is also known as a "stock swap" or "stock swap".
example: The Entertainment AG would like to buy the Sport AG to expand the portfolio. This is expected to cost 30 billion euros. Entertainment AG, however, has only 10 billion euros in cash. However, the value of the company's own shares is 100 billion euros. Entertainment AG uses 20 percent of these shares to buy Sport AG along with the 10 billion euros in cash.
Note: Local stock corporation law even requires the use of own shares for certain transactions. This means that a company may not be able to finance a takeover entirely with cash.
Share buybacks for employee participation
A stock corporation has the option of issuing employee shares. These can increase the motivation and identification of the employees, as they see themselves as the owner of their employer. A discount on the actual share price is common when the company's own employees buy the shares. In return, the maximum number of items available per employee is usually limited so that this benefit cannot be used indefinitely.
In order for the company to be able to issue shares to its own employees, it must, for example, carry out a capital increase, i.e. subscribe for new shares. Alternatively, it can use its own shares from share buybacks for this purpose.
Note: The discount or discount for employee share programs is taxable as a pecuniary benefit. If the applicable exemption limit (not tax exemption) is exceeded, the entire amount that an employee "saves" through the employee shares must be taken into account for tax purposes.
The instrument of share buybacks can also lead to a price increase in that individual key figures improve by reducing the number of tradable shares. For example, a lower number of shares results in an increase in EPS (earnings per share) or a reduction in the PE ratio (P / E) if the general conditions remain the same. Since an unchanged company value is distributed over fewer shares, investors often expect prices to rise due to share buybacks. However, if other company key figures change negatively, for example, prices can fall despite the share buyback program.
Influence on the shareholder structure
With the implementation of a share buyback program, a company or its owners can hope that a lower number of shareholders will be the result. Fewer shareholders can be the cornerstone for easier decision-making at the general meeting. Especially if camps with different plans and ideas have developed in the past. These can make a company incapable of acting and block structural changes. If some of these investors give up their shares as part of the share buyback, the majority of the decision may be postponed.
Signal to the capital market
If the management of a company considers the price of the shares to be undervalued, it can send this message to the capital market with the help of a share buyback. By buying its own shares, the company can make it clear that it currently considers its own shares to be one of the best investment alternatives. This signal can induce other capital market participants to take a closer look at the company or to buy its shares as well.
Accounting for share buybacks
After a company has bought back shares, it must show these separately in its own balance sheet. For this purpose, the balance sheet item “repurchased shares” is common in German-speaking countries. Shares bought back generally reduce a company's equity because they were paid for with funds that disappear from the balance sheet. The active balance sheet item “Cash” usually serves as a counter position.
For example, if the value of cash falls from EUR 1,000 to zero as a result of share buybacks, equity is also reduced by this value. As a direct consequence, the level of indebtedness increases and the equity ratio decreases. There is a reduction in the balance sheet.
The instrument of share buybacks can even be used until the balance sheet item “Equity” becomes negative and therefore loses its informative value considerably. Thanks to the separate balance sheet, investors can also view equity without the influence of share buybacks.
In the case of a debt-financed share buyback, the equity ratio drops more sharply than in the case of a purchase with own funds. This is due to the fact that the balance sheet total does not change. Instead, outside capital is taken up and the equity position is reduced. The liquid funds remain on the balance sheet because they have not been used.
Share buyback - interpretation & meaning
In practice, share buybacks can indicate both negative and positive aspects from an investor's point of view. In addition, the repurchase of own shares can have a different influence on other market participants such as competitors or banks than on the investors in a company. Therefore, when interpreting share buybacks, both their scope and the respective perspective are relevant. In the following, the focus of the evaluation is on the view of the shareholders.
Tends to have a positive signal effect
A major advantage of share buybacks is the opportunity for additional price increases. In principle, the lower number of tradable shares has a positive influence on the price and, in this context, ensures higher shareholder value. The tax deferral effect that has already been carried out also has a positive effect. In addition to increasing the share price, share buybacks can also be an instrument for reducing volatility. For its part, management can build up additional demand in order to limit price losses. From the company's point of view, the comparatively low purchase price of the shares is positive.
Another advantage of the smaller number of shares is that the dividend tends to be higher. If a company pays out an unchanged amount of money, buying back shares increases the dividend yield for all remaining shareholders.
Opportunity for sellers
Investors who might want to sell a stock can usually do so through a tender process at a premium. You get a higher selling price than if you had placed the order on an exchange.
For a positive assessment of a share buyback, the question of the origin of the liquid funds can also play a role. For example, if the money comes from the sale of a part of the company, it may not be sensible to invest it in further company growth. The share buyback, for example, would be rated more positively than if the funds came from operational business and there were no investment opportunities.
Critical aspects of share buybacks
One of the central points of criticism of share buybacks is that the price increases achieved by a share buyback do not necessarily have to be sustainable. In this case, they do not provide any added value for the company or its shareholders.
Rather, the repurchase of shares can be an indication that there are no alternative ideas for investing liquid funds. This can indicate low growth opportunities and a saturated market. Low company growth can also negatively affect returns. This form of price maintenance can also be used to divert attention from fundamental problems of a company by “calming down” the shareholders. In addition, the money used to buy back shares may be lacking in later investment projects. This can slow down the growth of a company again.
Another risk arises in the valuation of the share itself. A share buyback during a phase of price strength can lead to a company buying back shares at a price above their fair value. This would only benefit those shareholders who could sell their shares at this price. For the remaining shareholders, buying back shares at high prices tends to be disadvantageous. This can have an impact particularly in times of crisis because there is less liquidity and financial leeway.
The possibly only short-term effect of price increases through share buybacks can in principle also be misused. In corporate practice, manager bonuses can also depend on the price of the stock. This can create an incentive to use share buybacks to raise the price to the desired level on the respective reporting date in order to achieve one's own financial advantage. The sustainability of this measure is not necessarily taken into account.
Negative influence on the index weight
While the falling number of shares in the free float is often rated positively, this can also result in disadvantages. For example, the index weighting of a company depends exclusively on the price of all freely tradable shares (market capitalization). However, if the price of a company does not rise to the same extent as it bought its own shares, the weight in an index decreases. For example, if a company were to buy back five percent of the shares in circulation, the price would have to rise sustainably by five percent.
While a lower percentage of an index or a descent into a lower index does not in itself mean any disadvantages, the share price can come under pressure through the sale of funds. Index funds (ETFs) in particular represent a supply and demand factor that must be taken into account. A lower market capitalization or a decline from an index can mean that ETFs have to sell a considerable amount of shares at short notice. This can weigh on the share price.
Possible disadvantage due to a change of index
If a share moves down from the DAX to the MDAX, all ETFs on the DAX are obliged to sell this share. The fund volume on a country's leading index tends to be larger than the volume in small caps. Because of this, there is less demand for the company's shares than before. It can therefore be assumed that the share price may fall due to the index change.
Share buyback vs. dividend distribution
In principle, both share buybacks and dividend payments are a way of returning equity to shareholders. In the case of dividends, it is freely available to shareholders as cash. In contrast, when buying back shares, investors are not free to decide how the money will be used. You can only rely on the positive price effect in order to be able to sell the stock at a higher price than before. If, on the other hand, the price increase has a lasting effect, it may be preferable to a dividend payment from a tax point of view.
Shareholders who bought a share before 2009 have a special position here. They are not required to pay capital gains tax at the time of sale. A price increase is practically tax-free for these shareholders. The advantage of the share buyback over the dividend distribution is consequently greatest in this special case.
Allianz announced the buyback as part of an ad hoc announcement on February 20, 2020. In the appendix to the annual report (p. 80), the company takes a more precise position on the effects of the share buybacks and explains them. The total number of shares issued fell by around five million in the period under review.
Until the price slump due to the Corona crisis, the price picture is positive for the period of the share buybacks. The buybacks may have contributed to this.
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