Why Would a Company Buy Its Own Shares? Fewer Slices of the Same Pie

A company generating surplus cash can hold it, invest it, pay it to shareholders as a dividend, or use it to buy its own shares on the market and cancel them. Buying and cancelling reduces the number of shares in existence, so the same total profit is divided among fewer of them and earnings per share rises arithmetically. Each remaining shareholder owns a slightly larger proportion of the company without having done anything. The total value of the company falls by the cash spent, so this is a transfer of cash to those who sell rather than the creation of value, which is the point that arguments about the practice turn on.

Both return cash to shareholders and the differences matter:

• •A dividend is expected to continue, while a repurchase carries no such expectation
• •Cutting a dividend is punished severely, so raising one is a lasting commitment
• •Shareholders choose whether to sell, so they choose when to realise the cash
• •Tax treatment differs, frequently favouring capital gains over dividend income
• •Earnings per share rises, which frequently affects executive pay targets
• •Shares can be repurchased to offset those issued to employees

The practice was prohibited or severely restricted in the United States and elsewhere for decades, on the reasoning that a company buying its own shares is trading in its own security with better information than anybody else, which looks like market manipulation. That changed in 1982, when a rule was introduced providing a safe harbour for companies repurchasing within stated limits on volume, timing, price and method, after which the volume of repurchases grew enormously and now regularly exceeds dividends in aggregate. Britain permitted them from 1981. Several countries retain tighter restrictions. The manipulation concern did not disappear and was addressed by the conditions of the safe harbour rather than by being resolved.

Repurchasing is more regulated in its mechanics than the idea suggests, since a company buying its own shares could easily move the price. The common method is an open market programme, in which a broker buys gradually over months within limits on how much of the daily volume may be taken and at what price, and companies announce these in advance and are not obliged to complete them. A tender offer invites shareholders to sell a stated quantity at a stated price above the market, which is faster and more expensive. An accelerated arrangement has a bank deliver the shares immediately and acquire them over the following months, taking the timing risk. Companies are generally barred from buying during periods when they hold unpublished information.

Criticism has intensified as volumes have grown and the objections are substantive. Critics argue that cash spent this way is cash not spent on wages, research or capacity, and that the practice reflects a short-term orientation in which raising the share price substitutes for building a business. They point to executive pay linked to earnings per share, which gives management a direct interest in reducing the share count. And they note companies repurchasing heavily and then requiring public support in a downturn. Defenders reply that returning cash a company cannot use productively is correct, that shareholders reinvest it elsewhere, and that the alternative of hoarding or wasteful investment is worse. Several jurisdictions have introduced taxes on repurchases in response.

Buying and cancelling shares divides the same profit among fewer of them, so earnings per share rises without the business changing, and the company is smaller by the cash spent. It is preferred to a dividend because it carries no expectation of continuing and because tax treatment frequently favours it. It was prohibited as manipulation until a 1982 safe harbour in the United States, and volumes have grown enough to prompt new taxes.