How share buybacks work

Fsp Invest, 07 Jan. 2014

Tags: share buyback, dividends, return cash to shareholder, cash, investing, what is a share buyback, why does a company buyback shares,

When a company makes cash, there are three things it can do with it. It can invest the cash back into the business. Or it can stick it in the company bank account, and just sit on it. Or it can return it to shareholders. To do this, some companies return it to shareholders through buying back its shares. Read on to uncover how share buybacks work…

Traditionally, companies returned money to shareholders via a dividend, Ed Bowsher in Money Morning UK explains...

But an increasingly popular way to return cash is through a share buyback. This is when a company buys some of its shares back from shareholders. Most of the time, this is done during ordinary market trading.

How does this work?

Let’s imagine you own 100 shares in Company ABC. Over the course of a month, ABC buys back 1% of its share capital, but you don’t sell any of your shares.

You might think that nothing has changed for you, but you’d be wrong.

On the downside, you own shares in a company that has less cash in its bank account (or is perhaps even borrowing more to buy its own shares). But on the upside, you now own a slightly larger percentage stake in the company.

Why do companies buy back shares, rather than pay dividends?

The most persuasive argument for buybacks is that they save tax. If you’re a shareholder and you receive a dividend, you’re probably going to have pay tax on that dividend. But you don’t have to pay any tax when there’s a buyback.

A buyback can also cut a company’s tax bill. By buying back shares, a company is altering its capital structure (the way it’s funded).

Sometimes companies borrow to fund buybacks, so the company increases its debt and reduces its outstanding equity (shares). It’s cheaper to fund a company using debt because the company can deduct these interest payments from its corporation tax bill – that’s not true for dividends.

So there you have it, how share buybacks work.

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