Buyback may be even more profitable
As the shares are repurchased, additional demand appears in the shares. Buyers, all else being equal, become stronger, which leads to an increase in shares. This is true for the buyback of shares from the market, the most common way of selling the stock.
It is also possible to carry out a buyback as part of an offer, when the volume of shares is redeemed once from investors who have used the offer. This method allows to reduce the volume of supply, which is positive for quotations, but there will be no demand growth factor, as in the previous case. Next, we will consider the implementation of the program of share buyback from the market.
The positive influence of the buyback on the quotations is confirmed by the dynamics of the S&P 500 Buyback index, which reflects the dynamics of the top 100 companies from the S&P 500 index, which realize the largest buyback of shares. Since 1994, it has grown 8 times more than the S&P 500 index.
Over the past 10 years, the S&P 500 Buyback index has outperformed the S&P 500 by only 5.5%, but in December the gap was 58.1%. This trend is explained by the fact that many companies decided to suspend or cancel the buyback due to the coronavirus, which negatively affected the quotes.
Boughtback shares become treasury or quasi-treasury packages, which can be used in different ways. In this article we will consider two main applications: stock quenching and the launch of a management incentive program.
Equity quenching increasing profits per shareholder
Cashing in shares acquired through the buyback process is one of the best solutions for shareholders. If a company chooses to redeem the treasury stake acquired as part of the buyback, the number of shares in circulation is reduced and earnings per share are accordingly increased, all other things being equal. An increase in earnings per share may lead to higher dividends or a stronger buyback, which has a positive effect on the quotes.
Motivation of management improved financial results
Under the program, managers may receive remuneration in the form of company shares. Accordingly, in order to get as much as possible, top management should make every effort to increase the efficiency of the company and the value of its shares.
Savings on taxes
A standard tax of 13% is paid on dividends received in the Russian Federation, i.e. if a company allocates 100% of its profit to dividends, its shareholders receive only 87% of it.
In the case of a buyback, the situation is different the amount sent for buyback is not taxed, therefore, in a similar situation, not 87% of profit will be distributed among shareholders, but all 100%. It is worth saying here that 13% will still have to pay from the final financial result, but all the time until the shareholder sells the share, the buyback works as a tax-free reinvestment of dividends.
Let us consider a scenario where the same company pays dividends instead of a buyback, which are reinvested later.
At the end of the first year, the investor received RUB 8.7 per share (net of tax), or RUB 8,700, for which 87 shares were purchased at RUB 100 per paper. In the second year, after tax, the amount of dividends was already RUB 9,457, for which 94 more shares were purchased, and so on.
After 5 years, the investor received 51,528 rubles of profit. The difference between the first and the second option was 8,807 rubles, or 8.8% of the invested capital over 5 years. This is about 1.7% annually it is so much more profitable to buy back in this example.
This difference was due to the fact that dividends were reinvested net of taxes, while no taxes were paid on the buyback. At the same time, the entire capital of the investor is in the first, which in the second option is in the papers. From this point of view, the buyback is equivalent to a tax-free reinvestment of dividends.
The example is very crude, as the share price at the buyback does not necessarily depend on the net profit margin. The influence of buyback on the quotes can be both stronger and weaker than in the considered option. It depends on undervaluation/overvaluation of securities relative to the industry and market, development prospects, dynamics of financial metrics, free-float and many other factors.
It should be noted that in Russia a buyback may be even more profitable. In Russia, it is possible not to pay tax on the financial result if the securities are held for more than three years or if the second type of MIS deduction is used. That is, returning to the above example, under certain circumstances in Russia it is possible to avoid paying tax on income of 69,351 rubles. In such a case, buyback in the considered option becomes more profitable than dividends by 3.33%