Share buyback is when the company notify the current shareholders that they will be making an offer for their shares. There are 2 primary ways to execute a buyback program, on market and off market.
On market buyback is when the company directly engages with the market by buying its own shares on the market. Off market buyback occurs when it issues a notice to its own shareholders that they are willing to buyback shares at a set range of prices. Shareholders can then directly engage with the company to complete the buyback program.
The main difference between on market and off market methods is the prices paid. On market programs by definition repurchase shares at market prices. In Australia, off market share program are usually set a price below market. Repurchase price can be set below market because repurchase price in tax terms can be a combination of capital and dividend.
The franking credits in dividend makes up the shortfall of the repurchase price verses the trading price. The individual participants tax consideration can even make an off market purchase below market price attractive. The advantage for the company is that it bought its shares back at below market prices and auctioned off the franking credit on its balance sheet to the highest bidder.
Similar to dividend, share buyback can be considered a return of capital, albeit typically on a one off nature. While investors expect profitable companies to make recurring dividend payments.
A critical evaluation criteria for share repurchases by company management is: are there worthwhile investments we can make that will create value? If not then capital is best used by returning it to shareholders. This could be a result of a major gain from sale of business or assets.
As well as more efficient use of the balance sheet due to cash accumulation. Companies taking large amount of debt and instituting a buyback is commonly called dividend recapitalization.
ASX On Market Buyback List
Below is a list of ASX companies with current on market buyback program. Note this list is not exhaustive but usually all current on market buy back by companies in the Australia 200 Index is included here.
Qantas (ASX QAN) – Company announced $500 million share repurchase program in 1h 2016. As of time of writing, it is still ongoing.
Ansell (ASX ANN) – Announced $100 million on-market share purchase program in August 2015. Management aim to complete the program in the next 12 month. Note the total $100 million is in USD.
Asaleo Care (ASX AHY) – Current market buyback program is up to $100 million or 10% of the company whichever first. Management reiterated continuation of the program in FY 2015 results where it had $37.9 million to go.
Computershare (ASX CPU) – Announced $140 million on market buyback program in August 2015.
Buyback Value Creation
There is much debate if these actions can actually create value. Simply, companies are exchanging cash for shares on issue so current shareholders will share the cashflow that would have went to those shares that have been bought back.
There are 3 outcome as result of share buyback and only one actually creates value.
If the current share price is undervalued by the market. Were the growth is not priced in the share price or other investors does not recognize the intrinsic value of the current business. Buying back stock will reward existing shareholders that did not participate in the program.
Shares bought back cheaply and cancelled means that current shareholders will gain larger portion of future cashflow absent a buyback program.
Second scenario is if the shares are valued accurately by the market. The stock price and the implied yield matches the equity cost of capital. The shares are neither cheap or expensive which means but management does the right thing by returning capital to its investors. In this instance the repurchase program does not create value but is value neutral.
The key risk is the third scenario where the management waste capital by overpaying by buying overvalued shares. This means that capital is used to overpay for shares rather than creating value by doing positive return on investment projects. Unfortunately, it is the third case that most management falls under. Usually driven by stock option incentive programs, the goal is to push the share price as high as possible under their tenure.
As value investors, our goal is to buy companies that are mispriced by the market. We are neutral between dividend or buybacks however it is all situational. If a company is severely undervalued by the market then we would rather buybacks than dividends and vice versa. We would have most likely participated in the dividend reinvestment plan.