Why companies purchase their shares back

Why companies purchase their shares back

Share repurchasing has become a headline in number of instances. And you and I of course wonder why on earth a company should buy back its shares after issuing it. There are many reasons behind it,

• If the shares are undervalued

If the shares are undervalued the company could increase the value by repurchasing the shares at a higher price.

• The company is at the risk of being taken over

Despite the fact that the company is performing well, if a competitor approaches the share owners of the company and offer them a better price for their share they would be compelled to buy those shares.

But if this is not in line with the best interest of the company, the company can repurchase the shares back to the company and make it private equity.

• Optimize future dividends

The company has done well in a particular year and increased dividend in the year would require company to increase the dividend in the future years as well. And the company thinks that there are better investment opportunities to maximize share holder wealth, it might decide to repurchase a proportion of shares so that future dividend would be optimized.

This could be further analyzed using an example,

Maintains a constant payout ratio, (http://sajithexplains.blogspot.com/2010/05/one-of-methods-of-maximizing-share.html) of 50%, and the number of share holders are 10000. And the profit is $10M

Dividend per share = 10 000 000 * 50%

10 000

= $ 500

If the company buys 2000 of the shares,

Dividend per share = 10 000 000 * 50%

8000

= $ 625

Because the company had purchased 2000 shares, the dividend per share ratio has improved and also the earning per shares. Because of these improvements the market value of the shares would automatically increase.

Why do share holders like this???

• Share repurchase is normally done at a higher value than the current market value, hence share holders can gain instant capital gain
• There is a signaling effect to the market the share has been undervalued and hence would attract potential share holders as well.

So when you see news of a company repurchasing shares, dont get all excited.. just remember these points... :D