What is a buyout?
A buyout, also known as a share buyback, is when a company buys its own outstanding shares to reduce the number of shares available on the open market. Companies buy back shares for several reasons, such as increasing the value of the remaining shares available by reducing the offer or to prevent other shareholders from taking a controlling stake.
How does a “buyout” work?
A takeover allows companies to invest in themselves. The reduction in the number of shares in circulation on the market increases the proportion of shares held by investors. A company may think that its shares are undervalued and buy back to provide investors with a return. And because the company is optimistic about its current operations, a buyout also increases the proportion of profits that a share is allocated. This will increase the share price if the same price / earnings (P / E) ratio is maintained.
The repurchase of shares reduces the number of existing shares, which means that each represents a higher percentage of the company. The share’s EPS therefore increases while the price / profit ratio (P / E) decreases or the share price increases. A share buyback shows investors that the company has enough cash for emergencies and a low probability of economic problems.
Another reason for redemption is for compensation purposes. Companies often grant their employees and management stock rewards and stock options. To pay for rewards and options, companies buy back shares and issue them to employees and management. This avoids the dilution of existing shareholders.
Since share repurchases are made using the retained earnings of a business, the net economic effect to investors would be the same as if those retained earnings were paid in the form of dividends to shareholders.
How businesses buy back
Redemptions are done in two ways:
- Shareholders may be presented with a takeover bid, in which they have the possibility of submitting, or depositing, all or part of their shares within a given period at a price higher than the current market price. This bonus compensates investors for bringing their shares rather than keeping them.
- Companies buy back shares on the open market over a long period of time and may even have a share buyback program that buys shares at certain times or at regular intervals.
A business can finance its buyout by contracting debts, cash on hand, or cash from operations.
An expanded share buyback is an increase to a company’s existing share buyback plan. A larger share buyback accelerates a company’s share buyback plan and results in a faster contraction of its free float. The impact on the market of an extended share buyback depends on its size. A large and widespread buyout should cause the share price to rise.
The redemption ratio takes into account the redemption dollars spent in the past year, divided by its market capitalization at the start of the redemption period. The buyout ratio makes it possible to compare the potential impact of buyouts between different companies. It is also a good indicator of a company’s ability to restore value to its shareholders, as companies that make regular buyouts have historically outperformed the overall market.
Key points to remember
- A buyback is when a company buys its own shares on the stock market.
- A redemption reduces the number of shares outstanding, thereby inflating the (positive) earnings per share and, often, the value of the shares.
- A share buyback can demonstrate to investors that the company has sufficient liquidity for emergencies and a low probability of economic problems.
Example of buyout
The share price of a company underperformed the shares of its competitors even if it had a solid financial year. To reward investors and bring them a return, the company announces a share buyback program to buy back 10% of its outstanding shares at the current market price.
The company had earnings of $ 1 million and 1 million shares outstanding before the takeover, which corresponds to earnings per share (EPS) of $ 1. Trading at a price of $ 20 per share, its P / E ratio is 20. All other things being equal, 100,000 shares would be bought back and the new EPS would be $ 1.11, or $ 1 million in distributed profits out of 900,000 shares. To maintain the same P / E ratio of 20, stocks should trade 11% to $ 22.22.
$ 1 trillion
Purchases in 2020 from all U.S. companies exceeded this amount for the first time in history. Apple, Inc. alone authorized $ 100 billion in redemptions in 2020.
Reviews of share buybacks
A share buyback can give investors the impression that the company has no other profitable growth opportunities, which is a problem for growing investors looking for income and profit. A company is not required to buy back shares due to changes in the market or the economy.
The share buyback puts a company in a precarious situation if the economy is experiencing a slowdown or if the company is facing financial problems that it cannot cover. Others argue that buyouts are sometimes used to artificially inflate stock prices on the market, which can also lead to higher bonuses for executives. (For related reading, see “4 Reasons Why Investors Love Redemptions”)