22 - Stock Buy-back...Is It Financial Deception Or Value Creation?
Updated: Sep 14, 2018
Shareholders invest in Oil & Gas companies expecting to receive some form of financial reward and wealth redistribution. Therefore, Oil & Gas companies reward their shareholders by:
Retaining earnings for future investments,
or executing a stock buy-back program.
A stock buy-back (or more formally called share repurchase) is a popular financial reward to shareholders, especially when companies generate strong cash flow and have extra liquidity.
The terms "Share" and "Stock" are used interchangeably
What Is A Stock Buy-back?
It is a financial transaction where a company uses its cash to buy out its own outstanding shares from shareholders. Subject to local regulations, the repurchased shares are either:
held in the corporate treasury
How Does A Company Buy-back Shares?
There are five methods to buy-back shares:
Open Market Repurchase
It is the most common buy-back method as it accounts for almost 95% of all buy-back transactions. However, every company must take adequate measures to prevent stock price inflation. this can be performed by:
announcing its intention to buy-back its stock in advance
performing the buy-back over a long period of time (usually within 1 year)
avoiding any behavior that might appear to be manipulative to share price
TSX and SEC recommend that no more than 25% of the average daily trading volume is bought back by a company on a single day
If a company wants to buy-back a substantial portion of its shares as part of a recapitalization or a restructuring strategy, it can invite shareholders to tender their stocks for sale. In this method, the company:
offers to buy shares at a predetermined price within a specific period (~20 days)
offers the buy-back at a premium (~10%-20%) to entice shareholders to sell
Moreover, the firm holds the right to cancel its buy-back offer if shareholders do not tender enough stocks.
It is an alternative form of tender offer but with additional arrangements to make it an auction. The company who wishes to buy-back should perform the following:
invite shareholders to auction
specify a price range at which it is ready to buy shares
wait for shareholders to indicate how many shares they are willing to sell at different prices within the price range
conclude the purchasing price as the lowest price at which it can buy back its desired number of shares
In some occasions, a major shareholder wishes to liquidate his position in a company but can't do that at the open market due to:
insufficient liquidity in the market
sale can't be completed without negatively affecting the stock price
In such case, the stock price is negotiated directly with the company which usually leads to repurchasing the stock at a discount.
It occurs when a major shareholder threatens to perform a hostile takeover, thus leaving the company with no other option but to buy out the stock at a premium. Although unethical, but yet takes place in the open market.
Why Companies Buy-back Stocks?
Increase Shareholder Value
With stock buy-back, a company reduces the number of outstanding shares, yet maintains the same level of profitability. This leads to improving some financial metrics, most notably the Earnings Per Share (EPS).
Share Price Appreciation
In a depressed economy, stocks are usually undervalued. This leads companies to buy-back their stock in order to create artificial demand for the stock, thus driving up the price.
Also, when the market corrects itself and the stock price reflects its real value, companies usually proceed with reselling their stocks at a profit.
Dividends are usually taxed at a higher rate than capital gain (which is realized from selling a stock at a profit). This fiscal advantage is enjoyed by shareholders as it enables them to:
receive their financial reward as capital gain rather than dividends
differ their capital gain tax to a future period
Any Downside for Stock Buy-back?
While buy-backs are usually favorable to companies and shareholders, they might hide some unhealthy details such as:
the market is topping out, so companies are artificially boosting their stock price with buy-backs
agency problem, especially when executives compensation is tied to financial ratios and metrics
market manipulation to benefit short-term investors rather than long-term shareholders
industry is in a decline phase since companies couldn't find better use of their cash other than buy-backs
With the slow recovery of the oil and gas industry, and with investors' skepticism about the future of the industry, companies should study carefully their buy-back strategy in order to avoid any misrepresentation of their sincere intents, as some perceive buybacks as a mean of deception rather than a mean of trustworthiness.
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