When a company wants to purchase outstanding stock from shareholders, it has two options; it can redeem or repurchasethe shares.
Why Purchase Back Shares?
The reason corporations sell stock to the public is to raise money. Corporations sell stock for the first time to the public via an initial public offering (IPO). Once this has been done, the stocks then trade on the secondary market as they are continuously bought and sold via the public. The corporation does not receive any cash from sales in the secondary market. Conversely, there are reasons why a corporation would want to purchase back shares that it has issued to the public.
The amount of shares trading in the secondary market is always a concern for a corporation. This is so because the amount affects the earnings per share (EPS). EPS is an indicator of a company's profitability. Reducing the amount of outstanding stock on the secondary market increases the EPS and therefore the corporation appears more profitable.
The number of outstanding shares can also affect the stock price. A reduction in shares would lead to an increase in the share price due to the smaller supply now available.
Another reason to purchase shares is to regain majority shareholder status, which is obtained by owning more than50%of the outstanding shares. A majority shareholder can dominate votingand exercise heavy influence over the direction of the company.
Repurchases and Redemptions
Repurchases are when a companythat issued the shares repurchasesthe sharesback from its shareholders. During arepurchase or buyback, the companypays shareholders themarket valueper share.With a repurchase,the company can purchase the stockonthe open market or from its shareholders directly.Share repurchases are a popular method for returning cashtoshareholders and are strictly voluntary on the part of the shareholder.
Redemptions are when a company requires shareholders to sell aportion oftheir sharesback to the company. For a company to redeem shares, it must have stipulated upfront that those shares are redeemable, or callable. Redeemable shares have a setcall price, which is the price per share that the companyagreesto pay the shareholderupon redemption. The call price is set at the onset of the share issuance. Shareholders are obligated to sell the stock in a redemption.
Which One to Choose?
A company may choose a repurchase over a redemption for several reasons. When the stock is trading below the call price of redeemable shares,the company can obtain the shares for a lower costper share by buying them fromshareholders through a stock repurchase. The company might offer, as an incentive,to repurchase theshares at a higher price than the currentmarket, but below the call price of the redeemable shares.When a company enacts a redemption, the call price will typically be at or above the current market price, otherwise shareholders could incur a loss.
Examples of a Repurchase and a Redemption
A company has issuedredeemablepreferred stockwith a call price of $150 per share and has chosento redeem a portion of them. However, the stockistradingat $120 in the market. The company's executives mightchoose torepurchase thesharesrather than paythe$30-per-share premium associated withthe redemption.If the company is unable to findwilling sellers, itcan always use theredemption as a fallback.
Conversely, if a company currently pays a 3% dividend rate on shares outstandingbuthas redeemableshares outstanding that carry ahigher dividend rate, the company might elect to redeem the more expensive shares, with the higherdividend rate. Oneadvantage ofissuing redeemable shares is that itgives a company flexibility if they choose to buyback shares at alater date.
Companies can sometimesbuy and sell stock like investors. If a company's executivemanagementbelieves theirstock is undervalued, they may choose tobuy back sharesat theperceived-discounted price.If thestock price appreciates in the future,the company has the option of issuing shares at ahigher price per share, earninga gain from the sale when compared to theoriginal repurchase price.
The Bottom Line
A repurchase involves a company buying back shares, either on the open market or directly from shareholders. Unlikea redemption, which is compulsory, selling shares back to the company with arepurchaseis voluntary. However, a redemption typically pays investors a premium built into the call price,partly compensatingthem for the risk of having their shares redeemed.
