Shane Ingram, Contributor
DB&G ANALYST SHANE INGRAM
INVESTORS TRADITIONALLY focus on stock price appreciation (capital gains) and dividends as the primary sources of gains on equity investments, but there are several other useful, and often overlooked, ways to increase returns from equities. One such method is through a share buyback.
A share buyback, also known as a 'share repurchase', is where a company buys back its shares from the marketplace. A buy-back can be thought of as a company investing in itself, or using its cash to buy its own shares. The basic idea of the buy-back is that the repurchased shares are absorbed by the company and in so doing the number of outstanding shares is reduced. Depending upon its objectives, the company can either retire (permanently) the shares it purchases, or hold them with the intention to resell when the stock price recovers.
Typically, buy-backs are carried out through a tender offer or open market purchase. In a tender offer, shareholders are asked to submit, or tender, a portion or all of their shares within a certain time frame. The tender offer will state both the number of shares the company is looking to repurchase and the price range they are willing to pay (almost always at a premium to the market price). If the investors take up the offer, they will state the number of shares they want to tender along with the price they are willing to accept.
Alternatively, and actually more commonly, a company may buy back shares on the open market. In this case, the company is like a typical buyer in the marketplace. It is important to note, however, that when a company announces a buy-back it is usually perceived by the market as a positive signal, which often causes the share price to shoot up.
Companies opt to buy back their shares for a variety of reasons. In most cases, it is a sign that management believes the stock is undervalued. For example, management may feel the market has discounted its share price too steeply. A stock price may be battered by the market for many reasons including disappointing earnings, adverse company-specific events, or general economic downturn. Under these scenarios, the company has an incentive to preserve the value of the stock by buying back its shares.
IMPROVE KEY FINANCIAL RATIOS
Another reason a company might pursue a buyback is to improve its key financial ratios. Although analysts are generally weary of this motivation because it resembles accounting gymnastics, improvement in key financial ratios is often a necessary by-product of the buy-back process. Recall that share buybacks reduce the number of shares outstanding. Simultaneously, the buy-back results in an outflow of cash resources, which reduces assets and equity, ceteris paribus. Consequently, return on assets (ROA) and return on equity (ROE) actually increase. Of course, improvements in these ratios are widely viewed as positive investment signals.
Probably most importantly, the buyback helps to improve the company's price-earnings ratio (P/E) - the most well-known measure of stock value. Because the number of shares outstanding declines, earnings per share (EPS) increases and thereby the P/E falls. As the P/E falls, the stock becomes more attractive from a valuation perspective.
Against the general beneficial nature of buy-backs, several locally listed companies have announced an intention to buy back shares or have made amendments to relevant internal rules to pave the way for such a move in the future. The forerunner in this area is GraceKennedy Company Limited (GK). The price of GK shares has been shaved 32 per cent since the start of the year on the back of weak earnings stemming in part from the shrinking domestic income due to the adverse effects of the cement crisis. GK shares are also down 47 per cent over the last 12 months as the company endured challenging times in 2005, which culminated in profits slipping 4.44 per cent when compared to 2004. The general downturn in investors' appetite for equities also exerted downward pressure on the stock price over the period. Notwithstanding, the decline in the share price has occurred on fairly weak daily volumes, which has prompted directors to pursue this avenue to preserve the value of the stock.
Jamaica Producers (JP) also intends to repurchase some of its shares. Note, however, that JP has been relatively more resilient, having conceded only 18 per cent since the start of the year and 5.6 per cent over the last twelve months. While profits at JP collapsed during 2005 amid adverse weather conditions, product tampering and upfront costs associated with its expansion initiatives, observers generally believe that the reasoning behind this move relates to the fact that JP shares have consistently traded below its book value. Currently, with a book value of $40.56, each JP share trades at 0.70 of its book value.
Dehring Bunting & Golding Ltd. (DB&G) is also in discussions to have its share buyback plans approved by the JSE. DB&G is down 33.3 per cent since the start of the year and 32.4 per for the last 12 months. This occurs despite posting earnings of $882.3 million for the year ended March 2006, up 9.9 per cent on the previous year. DB&G also trades at 5.15 times earnings, which makes it one of the most attractive company's on the market from this valuation perspective. Informed by these facts, Directors are looking to buy back portions of its shares.
TIMELINE UNCERTAIN
Although the timeline for the respective approvals is still uncertain, there are likely to be significant first mover gains for those investors who decide to increase their holdings in these stocks. Of course, the buy-back is not the only factor that makes these companies attractive options at this time. GK has redoubled efforts to develop its people, move closer to the final consumer, grow international business, and achieve operational excellence in what it describes as 'configuring for growth'. DB&G is also an attractive long-term entity given its resilient business model built on a diverse set of income streams and nimble organisation culture. JP suffered major catastrophes in 2005 and so barring a repeat of these conditions, the company is expected to lead the market in terms of growth in profits for 2006.
Disclaimer: All information contained in this article has been obtained from sources that DB&G believes to be accurate and reliable. All opinions and estimates constitute the author's judgement as of the date of the article. No warranty as to the accuracy, timeliness or completeness of this article and as to the opinions based thereon is given or made by DB&G. DB&G and/or its employees or directors and/or any associated person may have an interest in, or interest in the acquisition or disposal of, the securities or class of securities mentioned herein. Call 1-888- CALL DBG if in doubt about the content of this article. Decisions based on information contained in this article are your sole responsibility.
