Why do companies buy back their shares?
The main reason companies
buy back their own shares is to switch cash from mature sectors and investments
to new sectors or expanding companies. Share buybacks are an increasingly frequent
and healthy phenomenon. When there are no investment opportunities offering
a return commensurate with the required rate of return, management returns cash
to shareholders, who, presumably, can find investments that meet their requirements.
Here we are reminded of M. Jensen's theory of free cash flow: when a company
buys back its own shares, at least it is not undertaking a risky diversification
or massively over-investing!
Shareholders and management can have other reasons for wanting to buy back shares:
- A change in the relative weighting of shareholders between those who refuse to sell their shares to the company for reasons of control (i.e. in order to increase their percentage of ownership) and those who agree to sell some of their shares, hopefully at above their market value. This happened recently with Peugeot.
- Tax reasons, as it is often less costly for shareholders to get cash in the form of a share buyback than in the form of dividends;
- To send out a positive signal, i.e. that management considers the company to be undervalued. Buying back shares and cancelling them increases the value of the remaining shares. Given the recent movements in some stocks, this can be a very strong incentive.
- Leverage from debt, for the related tax benefits. This is not a very compelling motivation, as it overlooks the fact that debt and equity become riskier after a share buyback and thus more costly. The tax benefit is often illusory, especially as the company loses some financial flexibility. If share buybacks reduced WACC, companies would always be massively buying back their shares!
- Building up a reserve of shares to be used later for stock option awards or as a currency for an acquisition.
- Smoothing out share price fluctuations in the case of listed companies. But whatever is bought can be resold, and such buybacks, which are often in tiny doses, are tightly regulated by market authorities;
- Creditor considerations: share buybacks reduce a
company's solvency and thus increases its risk and diminishes the value of
its debt. But as creditors can oppose a capital reduction, this reason is