A share repurchase refers to a transaction where a company buys back its own previously issued shares. A share repurchase can be considered an alternative to cash dividends, as the corporate uses its own cash to buy back the shares.
Once the shares have been repurchased, they are referred to as treasury stock or cancelled, and are not eligible for dividends, voting etc. For all practical purposes, the number of outstanding shares is reduced by the number of shares repurchased.
There are various reasons why a company chooses to repurchase its shares:
- If the company perceives the shares to be undervalued or wants to support the share price.
- The company wants flexibility in distributing cash to the shareholders.
- To take advantage of tax structure, in markets where capital gains taxes are lower than taxes on cash dividends.
- To reduce/restrict the number of outstanding shares that might have gone up due to stock split or any other reason.
- To avoid a possible takeover attempt by a large shareholder.
Methods of Share Repurchase
A company can repurchase shares in four different ways:
- Buy in the open market: The most straightforward way is to buy the shares in the open market. In this method, the shares will be purchased directly from the market at the current market price. The board of a company may authorize to buy a number of shares in this manner. This method offers a lot of flexibility as the company may choose to buy shares at a convenient time. This method is also cost effective compared to other methods.
- Repurchase a fixed number of shares at a fixed price: Under this method, the company will make a fixed price offer to purchase a fixed number of shares at a fixed price. This price will usually be above the prevailing market price. For example, a company may make an offer to buy 1 million shares at $20 per share. If shareholders offer to sell more than this number of shares, the company will buy shares from different shareholders on a pro-rata basis.
- Dutch auction: This works similar to the fixed price purchase, but instead of specifying a fixed price, the company sets a range of acceptable prices (minimum and maximum). For example, an offer to buy 1 million shares in a price range of $18 to $22. The different shareholders will then quote the price at which they are willing to sell their shares. After receiving all the bids, the company will qualify these bids starting from the minimum price and then moving up until it has qualified 1 million shares. If the price at which these one million shares were qualified is $20, then all these shareholders who bid, 18, 19 and 20, will be paid $20 per share for their shares.
- Repurchase by direct negotiation: Under this method, the company will negotiate the price of shares with certain large shareholders and buy the shares from them. This price will usually be higher than the current market price. A company may do so in order to keep away any large shareholders gaining representation, or a possible takeover attempt.