When companies have excess liquidity they may decide to use that money to fund business expansion projects. But if this is not in the plans then management may choose to distribute the excess to pay dividends to its shareholders, usually in cash. Alternatively you can take is the buyback.
It is a program in which companies decide to withdraw some of its own shares in the market through a buying process either through the stock market or directly to shareholders at a fixed price.
Buyback programs reduce the number of outstanding shares, but has no effect on revenue of the company. Rather they help companies to invest in themselves if it is considered that the shares are undervalued and offer a good return to shareholders.
Management may decide to implement a share repurchase program for several reasons, including
– Confidence in the future of the company; – Leverage a low valuation of the share price in the market – Create more value for shareholders and would correspond a higher proportion of profits
In most cases when companies announce a share buyback program, management says there is no better investment than in their own actions. But this is not always the case, as it may be a sign that the company lacks growth or expansion projects.
They can also decide on these programs to improve the financial index of the company.
The repurchase tends to improve financial ratios of the company because as we have said, in the process the number of shares outstanding is reduced, and once the company acquired the canceled or held in treasury.
As there are fewer shares earnings per share (EPS) increase. It’s like the same cake spread among fewer individuals, all will be up a greater proportion.
If the company uses its cash reserves for the repurchase, this means that their assets will be reduced, since money is an asset. This makes the return on assets or ROA also improve with an increase.
The buyback also implies that there will be less equity in circulation, which means that the return on equity or ROE improve upward.
As for the price-earnings ratio (P / E), it is known that the lower its value is better because it can be a sign that stocks are cheap or undervalued. When the buyback applies this index can be lowered due to the increase in earnings per share (EPS), and this would be very attractive to investors.
We must not overlook the tax effect. While dividends are taxable as ordinary income, to repurchase the shareholder pays tax only if they decide to sell their shares and there are capital gains.
The repurchase program is very similar to payment of dividends, only instead of receiving cash dividends, what happens is an increase in the value of shares remaining.
But when a company announces this type of program it is important to analyze how they will fund because if recourse to borrowing could weaken its financial statements.