A share buyback refers to the purchase by a company of its own shares from a shareholder. There are various requirements under Part 18 of the Companies Act 2006 which limited companies have to abide by in order to be permitted to purchase their own shares. For example, the buyback can only be financed out of distributable reserves, the proceeds of a fresh issue of shares or, for a private limited company, out of capital.
One of the most common reasons for a company repurchasing its own shares is to return a surplus of cash to its shareholders. A company may have excess cash due to outstanding profitability or the sale of a business. For example, as a result of their surging profits in 2021, Shell announced a $8.5 billion share buyback scheme, which is taking place during the first half of 2022.
Another reason for surplus cash could be that the company issued shares with the plan to use the capital raised to fund expansion. If not all of the funds were used, the company would not only have surplus cash, but also an unnecessarily diluted share structure. This is because when an individual purchases shares of a company they gain partial ownership which means that they are given the right to vote on certain matters. Moreover, shareholders will often expect a return on their investments through dividends. When applying the above scenario, it creates the situation where a company may be paying for the privilege of accessing funds which it isn’t using. Therefore, in this situation buying back some shares can pay off investors and reduce the cost of capital.
An important reason a company might pursue a buyback is to improve its financial ratios. From an outside perspective a buyback can give the impression that a company is financially healthy. Buybacks reduce the assets on the balance sheet. As a result, the return on assets is increased because assets are reduced. In addition, return on equity increases because there is less outstanding equity.
Share buybacks reduce the number of outstanding shares. This is because once a company repurchases its shares, it will cancel them or keep them as treasury shares. The result is a reduction in the number of outstanding shares. When a company reduces the number of outstanding shares, a company’s earnings per share is increased. Where a buyback enhances the earning per share, the price to earnings ratio is also improved, which can make a business more attractive to investors.
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