What’s the difference between an on and off market buy back?
Buybacks have been all the rage in last the few years. Triggered by the availability and low cost of capital, US-listed companies, in particular, have embraced the strategy with great gusto. The idea is quite simple; if you have excess cash in your company, why not buy back your own shares, in effect “investing in yourself?”
When described by someone like Warren Buffett, the concept makes complete sense: if you think your company is trading below its fair or intrinsic value, then the best investment may well be to buy your own stock, rather than doing something else with the cash you have, that may not have a positive impact on your business.
Historically, boards and management of listed companies are rewarded through share price appreciation and improvements in operational metrics, like revenue and earnings per share.
On-market buybacks, which simply involve a company stepping into the share market on any given day to buy shares and then cancelling them, have the benefit of increasing earnings per share. That is because if you cancel one share, but earnings remain the same, the earnings for each remaining share are higher.
The pessimist investor would suggest that an on-market buyback, rather than being an investment into oneself, shows that a company does not have the confidence, or options, to invest this capital and generate a higher rate of return elsewhere, as funds are essentially going out of the business.
An off-market buyback is an option that is somewhat unique to Australia, in that in many cases it is driven by returning excess capital to shareholders. In fact, most buybacks in Australia are actually used to return excess franking credits to shareholders.
Australian companies receive franking credits for every dollar of tax paid but can only attach a certain amount of these credits to each dividend. If this franking credit balance continues to increase, because the company is profitable, many boards may seek to pay these out and cancel shares at the same time. Given global investors have gotten no benefit from franking, this overwhelmingly benefits tax-free investors like superannuation funds.
The process is quite simple, in that a company will seek to buy back its own shares at a large discount to the current price, offering a capital loss in many cases, but to make up the difference with an even larger fully franked dividend payment. Ultimately, it has the same impact as an on-market buy-back, but it is an Australianised version.
