With the BCE takeover officially dead, BCE has announced that they will resume their dividend and start buying back shares. Just about everyone knows what a dividend is, but many investors may not understand what it means to buy back shares. After all, what sense does it make for a company to buy itself?
For the uninitiated, it may be disturbing to learn that the number of shares in a company does not remain constant. Many companies issue new shares over time, and this dilutes each shareholder’s ownership in the company.
There are many reasons why a company would issue new shares and they all have to do with paying for something. Stock options, when exercised, usually cause the company to issue new shares. A company might choose to raise money by making a secondary offering of new shares to the public. Corporate takeovers of other companies are often financed by issuing new shares.
All of these things dilute the ownership of existing shareholders. Is this a bad thing? Well, that depends on what the company gets in return for the shares. If they get more value than they give up, then this dilution actually helps shareholders. Otherwise, it hurts them.
It’s also possible for the number of outstanding shares to shrink. When a company thinks that its shares are undervalued, it can help its shareholders by buying its own shares on the open market and retiring them. So, if BCE buys back 5% of its outstanding shares, shareholders who hold on to their shares will see their fraction of ownership of BCE rise by about 5%.
Is this a good thing? Again the answer comes down to whether the company gives up more than it gets. If the shares truly are undervalued, then this helps the shareholders who keep their shares. Otherwise, it hurts them.
Let’s illustrate this with the traditional lemonade stand example. Suppose that there are 100 shares in a lemonade stand that has $500 in cash and expects $1500 in future profits. Then each share is worth $20. Suppose that some shareholders are pessimistic about future earnings and are willing to part with their shares for $10.
If the lemonade stand uses the $500 cash to buy back 50 shares and retire them, then there will be only 50 shares remaining to divide up the $1500 in future earnings. So, shareholders who don’t sell get to watch their shares rise in value from $20 to $30 each.
But what if the weather is about to turn bad and future earning are destined to be only $100? Before buying back shares, the business had $500 plus $100 in future earnings, or $6 per share. After the buyback there are only 50 shares to divide up the $100 of future earnings, or $2 per share. So, we see that whether a stock buyback is good or bad depends on whether the stock is under- or over-valued.