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With so little headroom left to grow into, carrying large amounts of equity capital on the balance sheet becomes more of a burden than a blessing. Shareholders demand returns on their investments in the form of dividends which is a cost of equity —so the business is essentially paying for the privilege of accessing funds it isn't using.
Buying back some or all of the outstanding shares can be a simple way to pay off investors and reduce the overall cost of capital. For this reason, Walt Disney DIS reduced its number of outstanding shares in the market by buying back Shareholders usually want a steady stream of increasing dividends from the company. And one of the goals of company executives is to maximize shareholder wealth. However, company executives must balance appeasing shareholders with staying nimble if the economy dips into a recession.
The bank has recovered nicely since then, but still has some work to do in getting back to its former glory. However, as of the end of , Bank of America had bought back nearly million shares over the prior month period. Why are buybacks favored over dividends? If the economy slows or falls into recession, the bank might be forced to cut its dividend to preserve cash.
The result would undoubtedly lead to a sell-off in the stock. However, if the bank decided to buy back fewer shares, achieving the same preservation of capital as a dividend cut, the stock price would likely take less of a hit. Committing to dividend payouts with steady increases will certainly drive a company's stock higher, but the dividend strategy can be a double-edged sword for a company.
In the event of a recession, share buybacks can be decreased more easily than dividends, with a far less negative impact on the stock price. Another major motive for businesses to do buybacks: They genuinely feel their shares are undervalued.
Undervaluation occurs for a number of reasons, often due to investors' inability to see past a business' short-term performance, sensationalist news items or a general bearish sentiment. A wave of stock buybacks swept the United States in and when the economy was undergoing a nascent recovery from the Great Recession.
These companies invested in themselves by repurchasing shares, hoping to capitalize when share prices finally began to reflect new, improved economic realities. If a stock is dramatically undervalued, the issuing company can repurchase some of its shares at this reduced price and then re- issue them once the market has corrected, thereby increasing its equity capital without issuing any additional shares. Though it can be a risky move in the event that prices stay low, this maneuver can enable businesses who still have long-term need of capital financing to increase their equity without further diluting company ownership.
Buying back stock can also be an easy way to make a business look more attractive to investors. By reducing the number of outstanding shares, a company's earnings per share EPS ratio is automatically increased — because its annual earnings are now divided by a lower number of outstanding shares. Also, short-term investors often look to make quick money by investing in a company leading up to a scheduled buyback.
The return on equity ROE ratio is another important financial metric that receives an automatic boost. One interpretation of a buyback is that the company is financially healthy and no longer needs excess equity funding. It can also be viewed by the market that management has enough confidence in the company to reinvest in itself. Share buybacks are generally seen as less risky than investing in research and development for new technology or acquiring a competitor; it's a profitable action, as long as the company continues to grow.
Investors typically see share buybacks as a positive sign for appreciation in the future. As a result, share buybacks can lead to a rush of investors buying the stock. A stock buyback affects a company's credit rating if it has to borrow money to repurchase the shares.
Many companies finance stock buybacks because the loan interest is tax-deductible. However, debt obligations drain cash reserves , which are frequently needed when economic winds shift against a company. For this reason, credit reporting agencies view such-financed stock buybacks in a negative light: They do not see boosting EPS or capitalizing on undervalued shares as a good justification for taking on debt. Then The Coronavirus Struck Forbes.
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