The disadvantages of a share buyback

Julie Brownlee, Fsp Invest, 14 Oct. 2014

Tags: share buyback, share buybacks, disadvantages of share buybacks, dividends

As the name suggests, a share buyback is when a company opts to buy back some of its own shares on the open market.

The rationale for companies buying back shares is to return cash to shareholders in an indirect way. In other words, not opting to return cash via dividends.

So why do companies opt for share buybacks? And what are the drawbacks of share buybacks?

Let’s take a closer look…

Why companies opt for share buybacks

If a company wants to return cash to its shareholders, it can do so by paying a dividend. Another way that a company can return cash is to opt for a share buyback.

The reason why companies opt for share buybacks is the company’s post -tax profits spreads over a lower number of shares. And this will increase the earnings per share (EPS).

When companies embark on a share buyback, they often borrow money to do it. The company hopes the share buyback leads to a higher share price as the EPS is higher.

But share buybacks don’t come without controversy…

The downside of share buybacks

A higher EPS doesn’t mean a company is worth more as a result. This is especially the case if the company borrows money to do the share buyback.

Also if a company opts for a share buyback when its shares are trading at a high price, shareholders can be worse off as a result.

As with other forms of investment, the only way a buyback really benefits the shareholders is if the company manages to buy the shares for less than they’re really worth.

Some also believe that management can abuse share buybacks. Management bonuses may link to the performance of EPS. The performance of EPS can improve just by doing a share buyback rather than growing profits, so this isn’t in the best interests of the shareholders.

So there you have it, the disadvantages of a share buyback.

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