The repurchase of shares refers to a situation where a company repurchases its outstanding shares from the open market by using the funds that the company has accumulated. By doing so, the company will be able to reduce the outstanding shares presented on the balance sheet (Also see Accounting – Preparation of Balance Sheet) of the company, thus increasing the value of outstanding shares remaining. Repurchasing the shares from the shareholders may help in blocking their control of the company too.
As share repurchase would often bring some consequences to a business, there are some reasons why the companies decide to buy back their own shares. Firstly, the shares of the company may be undervalued in the share market. This is a situation where the investors do not value them as much as its actual value recorded on the financial statements (Also see Financial Statements That Financial Accounting Generates). Thus, the management of the company can repurchase the shares at a price which is lower than their intrinsic value.
After that, the market will rectify the undervaluation, and the price of the shares will increase and get closer to the intrinsic value. This is the time where the company can reissue the shares back to the market with an increased price and so that it can gain benefit from it. In this stage, the market values the shares higher; thus, the equity capital (Also see Introduction to Capital Account) of the company will increase without having to issue any new shares.
Besides, the share repurchase helps to reduce the number of shares that are traded publicly or to reduce the company’s float. This increases the earnings per share (EPS), which results in an increase in the buying interest among investors towards the shares of the company. As the EPS increases, the shareholder value will increase too. Thus, this makes the shareholders be confident to and satisfied with the company invested.
The repurchase of shares can help to improve other financial ratios too. These ratios are what the investors will look at when choosing the companies that they want to invest. Thus, companies need to improve these ratios so that they can attract more investors. Some ratios that the share repurchase would improve include the return on assets (ROA), return on equity (ROE), as well as the price to earnings (PE).
To calculate the return on assets, one should divide the net income of a company by its total assets (Also see Understanding Asset Conversion Cycle). When the company buys back its own shares, it spends cash on acquiring the shares. As cash falls under the category of assets in the balance sheet, the assets of the company reduce. This causes the company’s return on assets to increase, which is a good sign. In the calculation of the return on equity (ROE), one should divide the net income by the shareholder’s equity. As the repurchase of stocks reduces the outstanding floating equity in the stock market, the return on equity will increase too.
The same concept applies to the price to earnings ratio. This is a ratio that measures the time it will take for the investors to recover the funds that they have spent on the purchase of shares. One should take the price per share and divide it by the earnings per share to arrive at the price to earnings ratio. As the earnings per share increases, this ratio will increase as well. People will take this as a good sign as this means that they can get high earnings with low share prices.
Companies may repurchase their shares by using different methods. For example, they can choose to repurchase the shares from the open market or by using the fixed-price tender method. After repurchasing the shares, the companies should note that the repurchase of shares requires some accounting treatments too. Thus, for those who are not sure about the correct ways of recording them in the financial statements, hiring an accounting firm in Johor Bahru can be a good choice.