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A share repurchase refers to the management of a public company buying back company shares that were previously sold to the public. There are several reasons why a company may decide to repurchase its shares.
For instance, a company may choose to repurchase shares to send a market signal that its stock price is likely to increase, to inflate financial metrics denominated by the number of shares outstanding (e.g., earnings per share or EPS), or to attempt to halt a declining stock price, or simply because it wants to increase its own equity stake in the company.
Impact of a Share Repurchase
When a company buys back shares, the total number of shares outstanding diminishes. It paves the way for a few different phenomena.
First, many technical analysis metrics such as earnings per share (EPS) or cash flow per share (CFPS) will increase due to a decrease in the denominator used to produce the figures. Thus, investors must be wary of the situation, as EPS and CFPS will become artificially inflated – meaning that the increase cannot be attributed to economic value creation activities such as boosting earnings or cutting costs.
Second, following the concept of supply and demand, we can predict an increase in the stock price. Assuming that the demand for the stock remains constant in the face of a reduction in supply, we can project that the price of the stock will increase. Once again, investors must be wary of the phenomenon as it may not result from legitimate improvements in the business’ financial health.
The Signaling Effect of a Share Repurchase
When a company buys back shares, it may be an indication that the company is facing very positive prospects that will place upward pressure on the stock price. Examples may be the acquisition of another strategically important company, the release of a new product line, a divestiture of a low-performing business unit, etc.
Just like institutional investors and private investors, company management wants to see the stock price of the company rise. This is because of their fiduciary duty to increase shareholder value as much as possible and also because these individuals are likely partly compensated in stock. Therefore, a capital gain benefits them personally.
A share repurchase generally signals to the market the company management’s firm belief that the price of the stock is going to appreciate in the short term. Going back to the concept of supply and demand introduced above, we see that under such assumptions the demand for the stock may well increase if the signal is recognized as such. It’s just basic logic that the company likely does not wish to acquire more of its stock unless it believes the stock is likely to increase in value.
Salvaging Stock Value through a Share Repurchase
When the stock price of a company declines below a number of support levels in a short period of time and does not show any sign of stopping, the company may choose to repurchase some shares in hopes that doing so will support the price of the stock and halt the downslide.
As discussed earlier, and if company management acts in good faith, a stock repurchase typically signals to investors that the stock price is likely to increase due to some positive factor. However, keep in mind that the company’s management may only be trying to prevent a decline in the stock price.
Thus, it is important to consider a number of factors in order to fully understand the implications of a share repurchase. Things such as latest trends in stock prices, recent EPS and CFPS figures, news bulletins and announcements, etc., can go a long way toward estimating the stock’s most likely reaction to the repurchase.
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