Finance and Share Buybacks – Their Economic Drivers, Psychology and Results
Wednesday, 7 October 2020
The plastics industry’s experience with Coronavirus in recent months has raised lots of issues about cash flow and how companies are financed. Many companies have had recourse to approach governments for state aid and some major customer sectors of the plastics industry have had to do this. But such aid does not come without strings attached. Often governments will insist on share buy backs being suspended as a condition of their help.
Prior to its acquisition by Berry Global Group Inc in July 2019; the FTSE 250 plastic packaging specialist, RPC Group, launched a share buyback programme in 2017, worth £100m, which they completed on 21 July 2017. But what are the ins and outs of share buybacks?
Philip Arnold and Excellence in Learning, provide a clear explanation of what Share Buybacks are and why they are used. Together with their economic and psychological drivers and the resultant impact on the share price of companies and their current status within the UK and the USA.
Share Buybacks - Their Economic Drivers, Psychology and Results
Share Buybacks are huge in the USA. They totalled $800bn per year in 2018 & 2019 according to J.P. Morgan. Although widely used in the USA, they are much less common in Europe, with Royal Dutch Shell being a notable exception.
Even Royal Dutch Shell has suspended its Share Buyback program in the wake of Covid-19. In fact so many industries have been badly hit by the economic impact of the corona virus in 2020, that the lack of liquidity (cash) has become a major issue. This has forced many companies to seek state aid. Many of those states have made the suspension of dividends and stock buyback programs a condition of that aid.
Share Buybacks are just one way in which companies might choose to give cash to shareholders, the other and much more common approach, especially within the UK and the EU, is through dividends. There is no reason why companies cannot both pay shareholders dividends as well as distribute cash through extensive share buyback programs.
Why do so many US companies operate Share Buyback programs? In part the reason is psychological. The Stock Market focuses on Earnings Per Share, EPS, especially in the United States, but also in the UK. EPS is a widely followed measure and any increase in the EPS of a company is treated as though it were an increase in the overall profits of the company, even though the total profits may be unchanged:
- Buying back 10% of a company’s shares will increase its EPS by 11%; 100/90=1.11
In this case the EPS has increased by 11%, whilst the total profits remain constant. The logical implication of the reduction in share volumes by 10% would be to increase the share price by 11%.
However, the psychological impact of the 11% EPS increase and the consequent 11% increase in share price, creates a stock market purchase momentum, that often carries the share price upwards, beyond the logical 11% share price increase.
The logical arithmetical 11% share price increase, causes more investors to focus their attention on that company and there may also be a tendency upon the part of some of those investors to misinterpret that 11% share price increase and attribute it to other unknown factors. To avoid missing out, some investors will try to catch and ride the upward price wave. Thus pulling more money and hence demand into chasing the limited supply of that stock, which would further serve to increase its share price. Also Share Buybacks tend to signal that a company believes its stock is undervalued.
There are many other practical commercial reasons why some companies prefer share buyback programs to dividends. Many of them operate extensive buyback programs that often span many years.
Share Buyback programs provide more flexibility than dividend policies. The Markets will penalise dividend cuts, more than they would reward dividend increases; but they tend not to punish decreases or suspensions of share buyback programs. In addition, credit rating agencies treat dividends as fixed charges when they evaluate future cashflows to assign credit scores.
In general terms, share buybacks are deemed to be capital transactions, which in most countries are subject to more favourable tax treatment than dividends, which are deemed to be income transactions and subject to the harsher income tax assessments.
More details are available on the blog at:
Philip Arnold Strategy Director, Excellence in Learning; Editor in Chief, The Excellence in Learning Foundation
FCA, FIC, FIoD, CMC, BSc Hons, Chartered Director
FCA, FIC, FIoD, CMC, BSc Hons, Chartered Director
