Fair Pricing Should Be Considered When Companies Buy Back Shares

Share buybacks are a widely debated business strategy.

Activist investors often push for them as a means to return cash to shareholders and avoid wastage. Corporate executives argue that they offer tax efficiency and can indicate an undervalued company. The objective is to increase the market’s valuation of each share by reducing the total number of shares.

However, critics are concerned that both groups are prioritizing their own interests over workers and long-term investment. Increases in stock prices after buyback announcements can be exploited by short-term investors for profit. Additionally, reducing the share count facilitates earning bonuses tied to earnings per share.

Studies on this matter have generated mixed results. A US study discovered that 29% of companies announcing buybacks were at risk of missing EPS expectations without them. A more recent UK study did not find a correlation between buybacks and EPS targets. Despite this, the US government has imposed a new tax on buybacks and tightened regulations.

Regardless of one’s perspective on buybacks, it is agreed that companies should conduct them efficiently and with proper management. This proves challenging, especially with large stock sales. Boards must maximize shares obtained per investment, minimize market risks, and keep commissions reasonable.

A new study reveals that many companies are falling short in these areas. Approximately 10% of companies are forming complex contracts with investment bank brokers instead of purchasing shares on the open market and paying a flat commission.

Accelerated share repurchase agreements appear advantageous on the surface, as brokers guarantee a specific discount on the volume-weighted average price over a four-month buying period. However, traders can manipulate the average by purchasing more shares on low-priced days and fewer on high-priced days. This enables them to control the benchmark. Brokers can generate significant profit at the expense of shareholders, despite the risk they take on.

The study, conducted by former Goldman Sachs alumni Joerg Osterrieder (now a professor at Bern Business School and University of Twente) and Michael Seigne, used UK data but noted the similarity of US practices. They discovered that Royal Mail spent £200mn on its 2022 buyback but only received shares worth £184mn. The rest went to the investment bank, resulting in an effective commission of over 8.5%.

“Companies and boards fail to realize that when stock prices become volatile, brokers can make an extraordinary amount of money at the shareholders’ expense,” says consultant Michael Seigne.

Royal Mail defended its buyback, claiming it offered appropriate value for money, capped expenses, and met program expectations.

Even experienced bank traders acknowledge that share buybacks do not always provide the best outcomes for clients. The timing manipulations involved can prevent optimal stock purchases.

This issue holds real-world significance, with global buybacks reaching a record $1.3tn last year, triple the level from a decade ago. The majority ($1tn) was in the US and shrouded in secrecy until new disclosure rules were implemented by the Securities and Exchange Commission in May. Pending a court challenge, these rules will reveal how many US companies are being disadvantaged in their buybacks. This information is vital for investors.

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