When do companies buy back shares using cash?

Having looked at how it is that a company’s decision to buy back shares from the open market can have a material impact on our investment position, we can now take a look at the circumstances under which a share repurchase will make sense for a company, and how it is that this will improve the ability of our investment to make recurring revenues into the future.

One of the ways in which a company can try to improve its capital structure is by using funds available in its cash balance to buy back its equity stake, which is to effectively use retained earnings that have been built up in the company through previous years’ earnings. Such a transaction proves to be beneficial for the company if the company’s book value of its shares is greater than the value of the shares trading on the open market. This essentially means that the company is able to recuperate a portion of the costs it incurred when it initially issued these shares, and effectively reduce its cost of capital.

Since a reduced cost of capital is actually considered to be a tangible competitive advantage, and would actually improve the ability of the company to earn a profit into the future, it is beneficial for both the company, and the long term investor to see such a transaction take place. However, if the book value of the shares is lower than the market value, it means that the company is going to effectively increase its cost of capital, and take a loss against its book value. While it is possible that there might be a small tax benefit in the short term to such a transaction, this sort of transaction should be somewhat questionable to a personal investor.

By keeping in mind how it is that the ability of a company to take on additional projects that will create value for investors depend on the company’s overall capital structure, we can see how it is that a share buy-back that improves the capital structure of the company actually improves its ability to take on profit-generating projects in the future. In taking on additional projects, the company is improving its ability to scale over the long term. However, in the short term, since the company is spending its cash balances and retained earnings on share buy-backs, the company is sacrificing its ability to invest in projects today. Even if the buy-back improves the company’s ability to invest in the future, it will degrade the fundamental value of the company in the short term. As such, a share buy-back from cash resources must be evaluated as an investment in the ability of the company to make investments in the future.

To put this decision into context we should ask ourselves if we feel as though the opportunities of the future will be worth more (in terms of present value worth) than the value generated by the opportunities of today, and if we can afford to wait that long for them.