A company life map - the rise and fall of a hot stock

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22. Share buyback

Country Bumpkin, like many growth companies, has paid for its expansion by raising money through the issue of new shares.

Occasionally, companies go the other way: they reduce the number of shares in issue by buying them back in the open market or direct from their own shareholders. Once bought back, the shares are cancelled, which means that the ones that remain are worth more.

What a curious manoeuvre. Rather akin to a snake swallowing its own tail. Why would a company do this?

Often the stated reason is that the company thinks its shares are undervalued in the market. By buying them back, it is reducing the number in circulation and theoretically that should lead to upward price pressure. (Cynics suggest that companies announce their intention to buy back shares just to stimulate their stock price, but often don't actually follow through).

Sometimes, the company may simply have more cash than it needs, and not know what to do with it. Some see a buyback as a sensible solution; others see it as a admission that management has run out of ideas. An alternative way for a company to give cash back to shareholders is to pay a 'special dividend' in addition to its normal interim and final dividends.

The company may may see the buyback as a away of increasing the net asset value per share

To see how this last example works, consider the case of a company with net assets of £28m and 20m shares in issue. Its net asset value per share is 140p, but the share price languishes at 120p.

The company spends £3m buying back 2.5m shares at an average price of 120p each. Now there are 17.5m shares in issue, and net assets have dropped by £3m from £28m to £25m. Net asset value per share has risen from 140p to 143p.

The increase in net asset value per share is not enormous, but if the difference between the pre-buyback NAV and the pre-buyback share price had been wider, the increase would have been larger.

Note that special shareholder approval is required for a company to buy back its own shares.

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