With the financial year now finished for many of the companies listed on the ASX, we can ready ourselves for the deluge of earnings reports that will come our way over the coming month.

Sure enough, there will be swags of lists put out by many of the brokers and analysts. Things like: ‘The 10 stocks most likely to surprise’, or, ‘Stocks most likely to disappoint’. Of course, nobody really knows what the companies are going to report — many of them will be burning the midnight oil just to get their results out on time.

Apart from the range of predictions about their earnings, another thing that always gets a lot of attention is what these companies will do with their cash. Naturally enough, shareholders want these companies to share as much as they can with them.

And it’s not just the small investors who’ve got their eye on the cash. Plenty of the fund managers will want their money as well. Better the money in their pocket, they reason, than sitting idle on the companies’ balance sheets, or worse, being wasted on some dud acquisitions.

The old argument about how much of a company’s profits should be paid out to shareholders is well-worn. The answer, in theory anyway, is that the company should retain enough to fund its current operations (and future growth), and to share the rest with its shareholders.

When it comes to sharing those funds, the most common way is via a dividend. But it’s not the only way a company can share its excess cash with its shareholders.

One way a company can use this cash is through a share ‘buyback’. As the name implies, it involves the company using this excess cash to buy back its own shares. Once the shares are bought, they are then cancelled, thereby reducing the number of outstanding shares.

You can see that reducing the number of shares by 10%, for example, should increase the remaining shares left over by 10%. It’s the same business, after all, just divided into a smaller number of shares.

There are two ways a company will usually conduct a buyback. The first is a tender (off-market), where shareholders can nominate the number of shares they’re willing to sell, and the price they’re prepared to accept (usually set as price range, designated by the company).

The other way is to buy the shares on the market, as any other investor looking to buy shares would. Qantas [ASX:QAN] announced in February this year that they intended to buy back up to $500 million of its own shares, via an on-market purchase, which they completed in June. All up, Qantas has reduced the number of shares on issue by 12.6%, since 30 June, 2015.

But why do companies buy back their own shares?

Why Companies Buy Back Their Own Shares

The short answer is that they believe it’s the best way to use available funds. And it’s here where management and shareholders opinions can diverge. While a special cash dividend (on top of the ordinary dividend) might give a ‘sugar-hit’ to existing shareholders, it’s usually just a one-off bonus.

However, management want to do something they believe will add value to its shares in the long term. Such as reducing the number of shares on offer which, importantly, flows through to how investors view (and value) the company.

For example, even if earnings remain the same, they are spread over a smaller number of shares after a buyback. That increases the earnings per share (EPS) — and also the cash flow per share — something seen as a positive by the market.

One way investors judge whether a stock could be overvalued is by its price-to-earnings (P/E) ratio. That is, if the P/E is too high. Of course, this is a subjective argument, based on a whole set of parameters, such as the sector the company operates in, and whether it’s a growth or income stock.

But even if earnings are flat from one period to the next, a higher share price per earnings lowers the P/E ratio, thereby making the shares look cheaper than they were prior to the company undertaking the buyback. As you’d expect, a buyback also helps improve a company’s return on equity (RoE) — another key number watched by the market.

Of course, not too much gets past the pros in the market. The multibillion-dollar fund managers know exactly how to value a business, no matter how many shares it has on offer. But one of the reasons they can be so sceptical about a share buyback is its timing.

Think about it this way: If a company buys back its shares at $40, and the shares subsequently fall to $20, then the company has just blown a big chunk of its shareholders’ cash. This scenario isn’t so farfetched. It’s exactly what happened to BHP back in 2011.

With the commodity bull market in full swing, BHP undertook an off-market share buyback, picking up $6 billion (4.4% of the company) worth of shares by April 2011. With the average price of the 147 million shares bought by BHP at $40.85 — well below the share price of around $47 by the end of the program — it looked like a great deal at the time.

But just over a year later, BHP was trading closer to $31. And after trading back up to a peak just below $40 several times over the next couple of years, BHP then fell to a low of just over $14 by the start of this year.

It’s only with hindsight that a company can know the best time to have bought back its shares. And therein lies the problem — no one knows what the market will do in the future.

If BHP had soared on to, say, $60, it would have looked like an even better deal. But that buyback now looks like a waste of cash — something that should have been used to lower debt, or disbursed to their shareholders who could have allocated it where they thought best.

Management looking to carry out share buybacks face the same dilemmas as everyone else in the market. When everything looks terrible, and the shares have been hit hard, they too are gripped with fear and want to hoard their cash — a time that often shows a company would have been better off buying instead.

And the timing of a buyback can also be a problem in a bull market. Quite often a company will buy its own shares at the top because there’s nothing else to buy — everything else is too expensive, or has little prospect of generating growth. Quite often this can prove to be the worst time to buy.

Coming into this reporting season, you’re going to see a range of articles about companies looking to undertake share buybacks. But unless their shares are undervalued at current levels, then chances are they too are going to burn up a whole lot of their shareholders’ cash.

Cheers,

Matt Hibbard,

Editor, Total Income

Editor’s note: The above article was originally published in Markets and Money.

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