Share repurchases by corporations have reached unprecedented levels in recent years and are expected to go even higher. In fact, in 2017 S&P 500 companies made share repurchases to the tune of $770 billion. This number is expected to reach $940 billion by the end of 2019, which is equal to about a 1/3 of the spending capital of these same corporations [United States: Shares Buybacks Under Fire, Mondaq].
So, what are share repurchases and why have corporations thrown a third of their money at performing them? Let’s take a look at what exactly a share repurchase means and why they may be beneficial to businesses. What is a Share Repurchase?A share repurchase is simply a corporation purchasing its own outstanding shares back from shareholders [Overview of Share Buyback Notice, Clausehound.]
An example of a share repurchase is: Company A has 100 shares outstanding. Each share of Company A is $1. Company A uses its own capital to purchase 50 outstanding shares for $50. But why are companies spending so much money buying back their own shares? The answer is because there are lots of benefits to share repurchasing.
Benefits of Shares Repurchasing
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Cheaper than Dividend Payouts:
- Paying dividends to shareholders can have specific tax implications that result in high tax rates [Taxation, Dividends, and Share Repurchases: Taking Evidence Global, JSTOR.] Particularly in most US states, a dividend payout is classified as a capital gain whereas money gained from selling a share is classified as ordinary income. So to encourage shareholder investment without paying out dividends, businesses can offershare buyback agreements that allow shareholders to be rewarded through the promise of having their shares repurchased at a specific date. Even in Canada or without tax benefits, corporations can use share repurchasing as simply a quick reward for shareholders that puts money in the shareholder’s pocket while the corporation still receives its own shares in return. In Canada, dividends are taxed with a separate dividend tax credit that is more advantageous than the standard income tax rates for high-earners. Even though the dividend tax rate is low, the capital gains tax rate is still the most advantageous making money earned through share selling more beneficial for earners than money earned through receiving dividends
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Taking Advantage of Undervaluation:
- Sometimes the stock price of publicly-listed businesses can fall due to market concerns or just bad press. If the corporation is confident that these concerns are unfounded, they can repurchase shares at this low undervalued price and place them back in the market when the concern or bad press has been resolved [Share Buybacks – Secret Weapon?, Mondaq]. Apple did just this in 2014 when it repurchased $14 billion of its shares after the stock value dropped due to a disappointing quarter [Apple Buys Back $14 Billion of its Shares in Two Weeks, NY Times]. At the time of repurchase, CEO Tim Cook said that this repurchase simply means the corporation is betting on itself.
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Upping Stock Prices by Creating Artificial Scarcity:
- Lastly and perhaps most obviously, share repurchases can increase the share price of the business due to the basics of supply and demand. If the business repurchases a large percentage of outstanding shares, the supply dwindles and demand increases. Due to the increased demand for a limited product, the price of the share is likely to increase as well [Share Buybacks – Secret Weapon?, Mondaq]. With these benefits in mind, it is no surprise that corporations are racing to repurchase shares and reap the rewards.
Takeaways:
- Share repurchases are when a corporation buys back outstanding shares.
- Share repurchases have increased at a large rate in recent years.
- Share repurchases have benefits such as replacing dividends, taking advantage of undervaluation, and upping stock prices.
- Share repurchases can be indicative of market inefficiency where money that would normally be used for R&D is going towards share repurchasing.