Do share buybacks increase the value of stocks?
One of the reasons why companies pursue share buybacks is that they feel their stocks have been priced too low by the market.
By buying back their shares, companies essentially create additional demand and liquidity for their stock, which help boost their share prices.
Companies also reduce their shares outstanding, which increase their earnings on per share basis that help them justify higher pricing for their stocks. But we know from market experience that while stock prices do increase in the short-term, share buybacks do not necessarily lead to higher stock price valuation.
Remember that share buybacks, similar to dividends, are ways for a company to distribute cash to stockholders.
If the market thinks a company is using its cash to buy back shares that would have otherwise been used for more productive investments, a share buyback could affect its stock price negatively.
But if the market thinks the company is sitting on a pile of cash with too few profitable projects to invest in, returning its excess cash in the form of share buybacks could actually increase stock prices.
For example, when Alliance Global Group bought back its shares in 2019, its return on equity of 9.9 percent was higher than its hurdle rate of 9.41 percent, which we computed based on the prevailing 10-year bond yield of 4.4 percent at that time, plus risk premium.
Because the return on equity was higher than its hurdle rate, the net positive return of 0.48 percent was considered as an opportunity loss for the company when it used its cash for the buyback.
This effect on the value of Alliance Global’s operating assets caused its share price to fall by 30 percent from its high by year-end despite the huge buyback, which amounted to P4.9 billion. The fall in market price of the stock also resulted in a 25.7-percent loss to its average cost of P15.20 per share for that year.
But in 2020 the following year, the contraction in the economy due to the coronavirus pandemic brought down Alliance Global’s return on equity from 9.9 percent to 6 percent.
Although its hurdle rate also fell from 9.4 percent to 8.5 percent last year, as interest rates cut down to historic lows, the low return on equity of the company resulted to a negative return of 2.5 percent.
The negative return indicates that the company was better off returning its excess cash through share buyback due to lack of investment opportunities.
So, in 2020, when Alliance Global bought back its shares, it empowered its stock price to recover strongly, rising from a low of P5.30 per share to P10.6 by year-end.
The rise in market price also enabled the company to gain by 54.4 percent over its average cost of P6.87 per share for the year. This year, Alliance Global’ stock price continues to go up on stock buybacks, as its negative return widens to 4 percent due to the rise in 10-year bond yield. Historically, if we look at past stock buybacks in Philippine Stock Exchange, we will find that the average residual return of stocks in the market is negatively associated with buyback returns at 34 percent correlation.
This means that when a company with rising positive residual returns repurchase its stocks, its share price will most likely fall in 34 percent of the time, which will result in buyback losses.
But if a company has increasing negative returns, a share buyback can help preserve and enhance its value in the short-term with higher stock price.
Over the long-run, in order to create value, a company must continue building its capacity to grow by reinvesting its earnings for the future.
Similar to cash dividends, stock buybacks are also considered cash payouts. The more cash the company spends on stock buybacks, the lesser earnings it reinvests for growth.
During good times where profitable projects abound, stock buybacks may reduce sustainable growth rates, which lead to lower share prices.
But in this time of rising interest and inflation, stock buybacks are probably the best way for companies that cannot earn their cost of capital to distribute excess cash. INQHenry Ong is a registered financial planner of RFP Philippines. Stock data and tools provided by First Metro Securities.
To learn more about investment planning, attend 89th batch of RFP Program this May 2021. To register, e-mail [email protected] or text at 09176248110
