Share buybacks are a strategy of returning capital to investors. They are commonly used by US companies. Although less popular in Australia, they are still utilized. A recent example of this was the Woolworth share buyback in May 2019.
What is a Share Buyback?
A share repurchase is where a company will buy back its shares from investors. This can be completed one of two ways; via an on-market buyback or off-market buyback.
In the on-market method, the company will directly go to the market and repurchase their shares from those selling, as any regular investor would.
In an off-market buyback, the company will offer investors the opportunity to sell their shares back to the company at a fixed price. This action reduces the total number of shares outstanding, in return investors will own a larger percentage of the company and a higher percentage of underlying earnings and assets, the share price will increase to reflect this.
The company will then either cancel the shares or hold them, so as they are not publicly traded. The EPS of the company will be artificially raised as the formula earnings/shares have been altered whereas the number of shares PE may temporarily decrease due to an increase in EPS.
Why does a company perform a Share Buyback?
Share buybacks are best completed when the share price is low, as the company is getting the best value for its money. However, they may be complete when the share price is high, this may often correspond with when the company is in a healthy financial situation to do so.
A repurchase can also be perceived by investors that the company does not have better opportunities for further expansion and growth. Although if the company does in fact see limited growth potential returning capital to investors for them to grow themselves is a decent option. Share repurchases just like dividends involve returning capital to investors as such has many of the same implications. One advantage of a share repurchase is its tax implication. As investors will benefit from the share increase without being taxed until selling their shares, whereas for dividends the recipient will be taxed in that financial year.
There is also an expectation in relation to dividends. One of the last things a company wants to do is to reduce their dividend, although not necessarily a bad thing this can influence investor sentiment as they may have invested simply for yield or may see this cut as reflective of the underlying state of the company. With share buybacks, there really isn’t as much expectation for the company to continuously and constantly deliver upon them, which means the share price may be more preserved in the case of a downturn where the company may otherwise have to reduce its dividend.
Since share buybacks are theoretically very similar to issuing a dividend to investors, they can utilize franking credits. In off-market buybacks, the company can select to repurchase shares with a cash component and a franked dividend component to those involved. This method can be used to make share repurchases extremely tax-effective and was recently utilized by Woolworths, we will explore this example later. Effectively this can significantly reduce the capital gains component of your tax implication and return a large number of franking credits to participants. Similarly, just like dividends, there is an Ex-entitlement date.
Woolworths Share Buyback Casestudy
In May of 2019, Woolworths completed a $1.7B off-market share buyback. Around this time many companies were returning franking credits to investors due to uncertainty in the federal election. Woolworths also exited their fuel brands at this time. 58.7 million shares were bought back and canceled. They were bought back at $28.94, representing a 14% discount to their current price of $33.64. They were purchased off-market and comprised a fully franked dividend component of $24.15 and a capital component of $4.79 per share.
Let’s see how this would work for an investor:
Say you have held 1000 WOW shares at $10 per share over a number of years. Your cost basis is hence $10,000. Recently you have considered selling your shares at the current price of $33.64, at which you would get $33,640, your tax implication in this case would be half of your capital gains (half of 23,640) which is $11,820. This would then be taxed at your current personal tax rate. Your personal tax rate would then decide if it would be better to participate in the share buyback or sell them on the market as per normal, and if you had other capital gains to offset.
Since the capital amount is $4.79 if you participated and sold your shares you would make $4790 in capital gains, allowing you to claim a capital loss of $5210 ($10,000-$4709). You would also receive a fully franked dividend of $24.15 per share, this equates to a gross dividend of $34.5 per share, with the $10.35 franking credit attached. For your 1000 shares, this would be $24,150 in dividends and $10,035 in franking credits. In total the capital amount plus dividend plus franking totals: $38,975. We can see that before tax this is larger than the normal method.
Here’s all the important information in a table for our examples;
- Shares Held 1000
- Cost Basis $10,000
- Market Value (at $33.64) $33,640
- Capital component in share buyback $4790
- Capital loss due to share buyback (10000-4790)=$5210
- Dividend Received from share buyback $24,150
- Franking credit received from buyback $10,035
Share Buybacks for the Low-Income Investor:
If you were in a low tax bracket say 19% and you participated in the share buyback you would receive $4790 as a capital component, you could then claim a capital loss of $5210. You then receive the dividend of $24,150 plus $10,035 (34,185) franking credits, of which you would have to pay tax on 19% of ie. $6,495.15 which you can then use your franking credits to completely reduce this tax to zero and then claim the remainder. That is (10035.15-6495.15)=$3539.85. So, in this example, you have effectively made $32,479.85 post-tax (4790+24150+3539.85) plus a large number of capital losses to offset any capital gains you have.
If instead, you had sold on the market you would acquire capital gains of $23640 which can be discounted 50% since you’ve held for over a year. Meaning you have to pay 19% tax on 11820 which is 2245.8. In this case, you would make $21394.4 profit post-tax and have no capital losses that could be used to offset any other gains.
Share Buybacks for the High-Income Investor:
Now let’s look at this same example for a high-income tax rate of 37%. In this case, if you participated you would still receive $4790 as a capital component, you could then claim a capital loss of $5210. You then receive the dividend of 24,150 plus $10,035 (34,185) franking credits, of which you have to pay tax on 37% of ie. $12,648.45 which you can then use your franking credits to reduce this tax burden to $2613.45. So, in this example, you have effectively made $26,326.55 post-tax (4790+24150-2613.45) plus a large offset for any capital gains you have.
If instead, you had sold on market you would acquire capital gains of $23640 which can be discounted 50% since you’ve held for over a year. Meaning you have to pay 37% tax on $11820 which is $4373.4. In this case, you would make $29,266.6 profit post-tax and have no capital losses that could be used to offset any other gains.
We can see in the case of the high tax bracket you would be ahead from not participating in the share buyback. However, if you had a large number of capital gains to offset participating may be the best option.