The Buying Back of Shares Is a Dangerous Financial Strategy - Essay Example

? Contents Introduction 2 Motives for stock buyback 2 Market perception 2 Financial Ratios 3 Ownership 4 Tax Benefit 4 Capital Gearing 5 Share/Stock Buyback 6 Conclusion 8 References 10 Stock Buyback Introduction Stock buyback or stock repurchase is a process under which the companies purchase their shares from shareholders. It can be said that through stock buyback company invests in itself they just use their cash to buy their own share it is a kind of alternative that is offered to in place of dividends as a means of returning funds to the investors. Company cannot be its own shareholder thus repurchased shares are absorbed and number of outstanding shares in market are reduced (Gustavo & David, 2003). There are different motives that would attract the companies to buy back the shares and there are different techniques that can be used to go through the process of stock repurchase. Different techniques that can are used by the companies for their stock buy-back are as follow: Company offers to purchase the shares from their shareholders at a premium price thus it gives value to them and extra return over price they actually had paid for the shares when they were bought. Companies often buy back their shares from the open market like an ordinary investor purchasing shares and making investment. It is often seen that the market and shareholders perceive the decision of the company to buy back the shares as a positive move and shareholders expecting higher returns stimulates stock price of the company (Larry, 1981). Motives for stock buyback Different circumstances and requirements of business conditions can influence management of share repurchase. Such motivating factors along with their reasons are discussed below: Market perception It is the perception of the shareholders and potential investors that exists in the market matters for future of company. Company is believed to use capital or extra finance available to them to buy back its shares thus giving the perception in market that there shareholders would be valued as they are provided the opportunity to trade possessed shares at the premium price (Udo & Richard, 2003). Thus removing any negative market perceptions that the stock price of the company has fallen and they have low future expectancy that what effects dealing of shares in market. It is often due to low earnings reported by the company in past some period, its operations effected by some scandal or lawsuit thus the share buyback is used as an option to remove any negative perceptions that are prevailing regarding the company in the market (David, et al., 1995). It is becomes necessary for the company to make the share buyback as market due to such instances and incidents might value the share price way low and shares are being traded at value that is below the expectancy of company thus in order to keep a standard for their shares in market and keeping value for their shareholders alive however it is believed that hike in share prices through this approach is of nominal period (Mansor, et al., 2011). Financial Ratios It is a usual practice in the market adopted by the investors before making any investment they make decisions on the basis of research and evaluation of the companies that are seem potential for the investment. Financial ratios of the company are most basic and foremost results that are used for the evaluation of the company. It is part of rational decision making of the investor as they evaluate their choice of investment before making the final decision (Amy, 2000). Thus share buyback can be the part of an accounting technique to get the desired results for the company as however it is the personal finance of the company that they utilize to buy-back the shares thus it is confidence that the companies have on their abilities that makes them repurchase the outstanding shares that are either absorbed or turned to treasury stock. Thus the purchase reduces assets of company as it is the cash that is being paid for purchase of the shares therefore one of most important ratios for investors return on assets (ROA) and return on equity both are affected as they the earnings remain same however total assets reduced and so the equity as there are lesser number of outstanding shares in the market (Gustavo & Roni, 2002). This motive of the company to structure their ratios using share buyback technique can be termed both as the manipulation and positive management efforts in order for the company to be sustainable. Recent example of the Siemens can be taken as the company CEO said that they would buy back up to €4bn of shares. Siemens forecasted a 15 per cent rise in earnings per share next year, compared with the €5.08 per share achieved in the 2013 fiscal year. Company management anticipates that this year revenue will at least reach the level achieved last year, when sales declined 2 per cent to €75.9bn (Chris, 2013). The most important financial ration P/E ratio that is thought to be critical for making purchase decision as it shows earnings available against the price paid for them. As a result of buy back the number of shares decrease however the earnings remain same that increase EPS while denominator in P/E ratio it is a good sign as P/E is thought to be better when lower. Therefore price of share remaining same and increase in the earnings per share (EPS) the P/E ratio of the company falls giving a positive reflection to the market regarding performance of the company. Ownership It is not necessary that the company is undergoing the stock buyback in order to give value to its shareholders or is trying to make a positive market perception for its company and the management. Stock buyback can be a serious management decision in order to centralize the ownership of the company as over the years shares are issued companies become more and more diluted thus to reduce dilution or voting power of the shareholders companies go for share repurchase. Dilution makes existing outstanding shares less valuable providing smaller percentage of ownership to every shareholder thus repurchase regains the value of shares and ownership strength to company. It is also the employee stock option technique used for reduction in dilution as it repurchases the stock from employees in order to remove excessive dilution as company have not achieved targeted earnings (Bens, et al., 2003). Tax Benefit Shareholders are paid dividends by the company that is the distribution of the profits of company. Stock buyback often takes place at the premium price thus some kind of value being provided to the shareholders if not dividend therefore in case of share buyback shareholders are undergoing a sale of shares thus receipts are required to be taxed under capital gains tax. However that is not much of a factor now as dividends previously were taxed at the rate as of ordinary income but now dividends are taxed separately with reduce tax rate. Thus it can be a factor in the decision making for the shareholders whether they want to sell the shares and get taxed under capital gains tax or receive dividends over a foreseeable future and get taxed as dividend income the receipts they get. Thus the factor of tax is a motivation for the shareholders rather than the company that is engaging in the buyback of their shares. Capital Gearing Capital gearing or the financial leverage in the general sense is the formation or structure of the capital or the finance that the company is using for its operations. Capital gearing determines the amount of long-term or short-term debt that the company is using in order to finance its non-current assets. Capital gearing differs from company to company and industry to industry however it is the management policy that is reflected in the financial leverage of the company. Financial markets and the investors closely analyze the capital leverage or equity structure of the company that would give them an idea regarding the approach of the organization and future prospects. Capital gearing ratio uses the same concept as discussed above regarding capital gearing of the company. It determines the ratio of long-term and equity (owner’s capital, reserves etc.) in the capital of the company. Ratios like debt to equity ratio determine the mixture of debt and the equity that is being used to finance the expenses of the company along with that interest cover and equity or debt ratio determine the sustainability of the company. It is important for the investors and the creditors to analyze and evaluate the gearing ratios of the company as they give them an idea whether the investing or providing debt to the company would be riskier or can its operations generate returns. However analysis is made keeping in view the respective industry, nature and structure of the business company is following. The Modigliani-Miller Theorem forms the basis of the corporate finance in the modern era. Theorem discusses the relation of the market with the financial structure of the corporate it evaluates that firm’s debt to equity ratio doesn’t affect its market value it depends only the income generated by its assets and equity holders are indifferent about the firm’s financial policy. However recent financial crisis raised much criticism over the theorem as it doesn’t hold true in the real world also called as “Irrelevance principle” holds true under number of assumptions that are bankruptcy costs, the lack of taxes, proficient markets and asymmetric information (Newsdesk, 2012). Irrespective of whether equity or debt is the expensive mode of financing the fact is financial institutions and banks (for which theorem particularly holds) are finding it difficult to raise finance. The concept of theorem is contravening today with the ability of the banks to raise insured deposits that are risk insensitive however debt finance is subsidized. There would be hardly any company that would be completely finance by the equity or completely debt financed thus in any case company with higher debt ratio is considered to be risky under the current circumstances prevailing in the financial market. It is due to the reason that the debt is riskier and expensive mode of finance then equity and higher debt ratio in the capital makes the investors insecure as the interest payments associated might not leave much profit to be distributed amongst the shareholders (Kibet, et al., 2013). Also in the case of liquidity creditors and debt owners are at priority then the shareholders who are owners of the company. In the case of the share buyback decision by the company equity reduces as the common stock is repurchased by the company and is either absorbed or turned in to the treasury stock in order to reduce dilution of the ownership. In such a scenario existing debt percentage would increase in overall capital gearing of the company. If the decision regarding the share repurchase has been made by the company thus it must possess that much of liquid assets (cash) that could be used to pay off the shareholders often it is seen that companies are short of such a level of finance that could be used for the buyback. Therefore companies desperate for buyback take loans from financial intermediaries or other institutions in order to finance their share buyback thus increasing leverage or debt ratio in capital of the company. Increasing debt to equity ratio increases the costs for the company that are priority costs (interest expense) that have to be paid from EBIT (Prof. (Dr). T. & J. Aloy, 2012). This cost being allowable deduction provides tax savings for the company however still savings are way less than actual cost and risks associated. Share/Stock Buyback After the analysis of the process of the stock buyback and its implications one thing can be said that it is purely a management decision whether to undergo a share repurchase or not. Equity or issuance of shares are seen to be mostly the preferable way of financing and when the company issues its common stock for sale in to the market for the general it is also after detailed analysis that this decision is made in order to generate finance for the company and it can be said from its own resources. Thus the decision to repurchase the stock is taken by the company management after some consideration as when they feel it to be right for the stability, sustainability and growth of the company. The factors that would motivate the company for the share repurchase revealed that the decision of the company for the share repurchase might be for some short-term gains just order to pull up the share prices, create an image of healthy returns from the company through manipulation of the financial ratios and thus creating a positive perception in the market regarding the operations of the company and send the message to existing shareholders and potential investors that the company cares for their stakeholders (Jordon, 2012). If the decision of the management for the share buyback is on these basis then there might be only short-term benefits that can be attained by the company and it is probable that it might not be able to support its claims in the long-term perspective. It is a fact that ratios like ROA and ROE after stock buyback positively defend the company’s claims however on the other hand if personal finance of the company (that would be liquid cash) is used for repurchase then liquidity position of the company would decline it might be hard for them maintain their short-term or day to day expenses from internally generated finance and might have to rely on short-term borrowings. On the other hand if debt financing is used for buyback of stock then it would increase the leverage costs of the company would increase (interest expense) and company would be seen as riskier by the potential investors (Gary, et al., 1999). The decision of buyback can also be that for the long-term purposes as to reduce dilution of ownership. It might be due to the reason that management wants to reduce voting power and centralize the decision making thus making board decisions easier to be made. It also reduces the responsibility of the company towards the shareholders as they are lesser in number while keeping their relations steady and strong with all the stakeholders as they are seen to be paying premiums in case of repurchase. Besides reduction in dilution there can be many other factor on which basis management would be making the decision of buyback depending upon competitive strategies and future plans of the company. Thus it cannot be said in general whether the share buyback is right or wrong in general for both the short-term or long-term purposes it is a matter of fact depending upon situation and circumstances that company is facing (Francis & Dr. R. R., 2012). Executives of Apple’s board were authorized to perform buyback of up to $500 million. In 1999 at the time of buyback decision was made the shares of Apple' were being marketed at $10 per share, but shot up by $24 to an amount of $34 per share however later declined to $10 and persisted for the next few years ( Daniel, Eran, Dilger, 2013). It was at that a strategy adopted by the Apple repurchase the shares as much of them were held by Microsoft. It can be seen by the example of larger companies like that of Apple that have been involved in buybacks often that is not final that whether decision is absolutely right or wrong. However later in 2003 Microsoft sold its outstanding AAPL shares while Apple under the stock repurchase plan had paid $217 million to acquire 6.55 million shares. It seemed to be good decision on the part of Microsoft however since 2005 after stock split of Apple and swift growth since, the present value the shares that were bought back from Microsoft today worth almost $6.6 billion, thus from 2003 it shows 3000% ROI, even though today's shares are down by nearly 29 percent from their 2012 peak ( Daniel, Eran, Dilger, 2013). It is not necessary that if once the policy of stock buyback has worked for the company it would do again. Pepsi CO, announced in 2010 that they will be increasing their annual dividend payout to $1.92/share from $1.80/ share that was 7% jump (Kelsey, Swanekamp, 2010). Along with that they also declared to buyback $4.4 billion in shares during 2010 and declared plan to buy back their $15 billion of common stock by June 2013 (New York Times, 2010). This move by Pepsi Co. showed an increase in stock prices that were rather low. Pepsi Co. is continuing its policy of share repurchase providing for the repurchase of up to $10 billion of Pepsi Co. common stock from July 1, 2013 through June 30, 2016 as previous policy expired. Dividends of the company are declared to be increased to $2.27 per share from $2.15 per share. Through the mentioned programs, the company expects to return a total of $6.4 billion to shareholders in 2013 (Street Insider, 2013). Thus Pepsi is making it a long-term policy of buyback it can be seen as its continuing policy to aggravate its share prices. Conclusion Stock buyback is management decision that has a strategic importance for the company however it has been seen that companies undergo stock buyback both for short-term or long-term purposes. It is not possible to say clearly that stock buyback in general is a good policy or wrong as it depends upon the conditions and the circumstances that the company is facing. Managements making decision of stock buyback for the short term are not considered to efficient more long-term perspective is appreciated however it is seen that large companies like Pepsi have constantly adopted the policy of stock buyback and created a hike regarding its share price as it offers growth in dividends. References Daniel, Eran, Dilger, 2013. Apple insider, Articles. [Online] Available at: http://appleinsider.com/articles/13/08/16/battle-of-the-billion-dollar-buybacks-apple-inc-vs-microsoft-corporation# [Accessed 15 November 2013]. Amy, K. D., 2000. Why DO firms repurchase stock?. The journal of business, 73(3), pp. 331-355. Bens, D. A., Nagar, V., Skinner, D. J. & Wong, M. F., 2003. Employee Stock Options, EPS Dilution, and Stock Repurchases. Journal of Accounting & Economics, 36(1-3), pp. 51-90. Chris, B., 2013. Companies, Industrial. [Online] Available at: http://www.ft.com/intl/cms/s/0/2db31af8-4771-11e3-9398-00144feabdc0.html# [Accessed 15 November 2013]. 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