“Capital Raisings” and “Share Buybacks” are terms thrown around on the AFR, in the news and by investors regularly. It’s for good reason as well – they’re integral features of company operations. Let’s break down what they mean, and how they impact your investments.
A share buyback (or share repurchase) occurs when a company announces that it will repurchase some of its outstanding shares from existing shareholders. In this transaction, the company can purchase shares directly from the market or it can offer its shareholders the option of tendering their shares.
Through this process, the company submits a tender offer to its shareholders, which specifies the number of shares targeted in the repurchase and a price range for these shares. Investors who accept the offer will outline the amount of shares they wish to sell, and at what price. Once the company has received all offers, it will determine the right combination of shareholders to purchase the desired amount of shares, at the lowest cost.
Given that the motivation for a public company is to maximise shareholder value, a share buyback typically increases shareholder value by delivering cash, as the perceived best use of capital at a given time.
Companies also undertake share repurchase programs when they consider their share price to be discounted to a large extent. Given a reduction in share price due to missed earnings expectations, regulatory changes or a poor industry climate, a share repurchase is indicative of management’s belief that the shares are undervalued – after all, logical management would not utilise capital to purchase overvalued assets.
Alternatively, companies may also look to a share buyback to boost its financial ratios, which can function as critical signals for investors assessing quality market opportunities. A repurchase reduces the amount of outstanding shares but does not alter earnings – Hence there’s an increase in EPS (Earnings Per Share) which is a key measure of profitability. Moreover, Higher EPS reduces the company Price-to-earnings (P/E) ratio, which is utilised to measure corporate value. Assuming a stable share price, increased earnings lead to a smaller P/E metric, indicative of better value on the market.
Beyond the key ratios, share repurchases also increase return on assets (ROA) as cash, an asset, is used to repurchase the shares, whilst a reduction in equity through less outstanding shares can increase return on equity (ROE). This is important because higher ROE and ROA are indicative of high business health.
A share repurchase boosts share price in two ways
Let’s turn to a real example and assess how these dynamics play out in the market.
Spotify (NYSE:SPOT) announced a $1 billion share purchase program to operate between August 21 of this year, and April 21, 2026. At the time of announcement, this value represented approximately 2.5% of the company’s market cap, a substantial financial commitment. As expected, the market responded well, and the share price jumped 5.1%.
Figure: The Spotify share price post share purchase grew rapidly above previous closing levels. Data Source: Capital IQ
A capital raise is, in layman’s terms, when a company approaches existing and or potential investors to request additional capital (money) in the form of debt or equity. This money can be utilised in a multitude of ways, but it’s typically used to grow the company through investing in a new product line, expanding operations, or undertaking an acquisition.
Alternatively, capital can be used by companies to address their mix of debt and equity (capital structure) by potentially pay off existing liabilities on the balance sheet that will save investors through reduced interest costs and more headroom for additional future debt.
An equity capital raise occurs where the company in question sells additional stock in its company for investment in return. The positives behind this method are that despite greater ownership being relinquished in the company, there is no requirement to repay any party for the investment. Instead, the cost of this capital comes in the form of investors expecting and demanding returns to come in the form of reliable dividends and greater stock market valuation.
Conversely, raising capital through debt functions, in the same way, you or I might borrow – we approach a lender to borrow money and promise to repay it with additional interest attached. Companies can do this by either directly approaching a bank, or by issuing corporate bonds, a form of tradable debt, on the market.
This is a riskier approach, as increasing leverage boosts interest expenses that can overwhelm poorly structured firms. However, it can be seen as advantageous given there is no requirement to sacrifice ownership for capital.
Share prices are representative of future expectations and outcomes. Thus, a debt capital raising is not likely to influence share prices too significantly, unless these expectations are altered. Also, because there aren’t any additional shares being raised, dilution is not a concern.
In the case that guidance by management in released reports outlines clear, productive uses for debt capital, share prices may increase as investors become increasingly confident that positive projects will be pursued, conducive to stronger corporate value.
Alternatively, increased interest payments and higher leverage may place a company at risk of default. Evergrande in China are a clear reflection of how the market responds to companies with present default risks. Accordingly, greater debt without the ability to adequately service it in the future will place downward pressure on share prices.
On an equity front, a capital raise increases the number of outstanding shares and dilutes the holdings of existing shareholders. On the surface, this will suppress share prices as each share now represents less ownership and reduced earnings (through a lower EPS value).
But like debt capital, actual share price fluctuations are dependent on market response. If an equity capital raise will be used to pay off debt, it will be looked upon less fondly compared to those funds being allocated to a value accretive acquisition opportunity. This is because investors have a preference for funds being used in productive ways that will enhance longer term share prices and earnings growth.
Value or Growth stocks?
If someone asked you Value or Growth, how would you answer? What considerations would you make in coming to your answer? And would you be justified in deciding this? Well for most investors, these decisions...
Oct 18, 2018
Investing Psychology – Understanding Our Own Biases
As Investors, it is important to be aware of our own biases that impact our decisions when we invest in order to limit them and therefore make more cognitive decisions to ultimately better your situation....
Dec 2, 2019
The Australian Market 2019 - A Tale of Two Stories
Despite a war between the two largest economies, an inverted yield curve and a presidential impeachment, markets around the world power on to new-highs. And yet the Australian market struggled to shake off the pre-GFC...
Jan 10, 2020
Ready to invest with Maqro today?Sign up to Maqro