One common practice among companies with shareholders is buyback or stock redemption. When companies sell stocks to raise money, they lose both ownership in the company and profits related to the ownership. Companies redeem stocks for several reasons, but some companies use a buyback as a method of increasing share price. While this seems to make sense, there's no guarantee that reducing the number of available shares of stock will outweigh a decline in stock price due to lack of faith in the company.
Stock Redemption Definition
A stock redemption occurs when the business buys back shares from stockholders. The organization does this for several different reasons: to buy out unqualified or unwanted shareholders before an election, when the company must buy out a departing owner or investor, when the court orders a buyout or to keep the total number of shareholders under the 500-shareholder limit for private companies. The firm could sell the shares to other shareholders, but sometimes they don't have enough capital to purchase all the additional shares.
EPS vs. Share Price
Because stock redemption reduces the number of shares held by the investors, it increases the EPS, or earnings per share. Generally, investors and company executives think that increased EPS translates to increased share price. Mathematically, however, that belief doesn't pan out. Leaving out the effect of taxes and emotions for the moment, consider what purchasing shares changes mathematically. When the company spends its liquid cash or increases its debt to purchase shares, the price-to-earnings ratio drops. That decrease is offset by the increase in EPS, which means that the actual share price doesn't change.
Effect of Taxation
When you use company capital or debt to buy shares you increase the company's value by a small amount. Less interest earning capital means lower taxes for the company. That results in a higher percentage of income. The value increases even more when the company purchases shares using debt since all interest payments are tax deductible. Buyback benefits remove tax penalties that increase the share price by up to 2 percent.
While there's no numerical reason for buybacks to increase share price more than slightly, emotions play a big part in determining the relationship between buybacks and share price. Some companies see share price increases by 2 percent to 3 percent for small buybacks and up to 16 percent for larger buybacks. However, buyback programs don't guarantee an increase in share price when the stockholders worry about company performance. Operational performance remains the No. 1 way to increase share price, but shareholders do like it when the company puts capital back into itself rather than something possibly wasteful like an unwise acquisition. One major drawback of unsupported EPS and share-price increase is a downfall in long-term investment health.
- McKinsey & Company; Number 3: The Value of Share Buybacks; Richard Dobbs; 2005
- The Business Owner; Case Study: Minority Share Buyback; 2011
- American Printer; Examining Stock Redemption Rules; Shelly Donald F., Jr.; August 1996
- TIME: Business; Stock Buybacks Return Despite Volatile Market; Janet Morrissey; June 2010
- Fredrikson & Byron P.A.; Stock Redemptions: An Improved Tool; Thomas W. Garton; December 2005
- The Free Library; Corporate Stock Redemption: Not Always Black & White; Robert M. Kozub et al; 1992
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