When a company wants to purchase outstanding stock from shareholders, it has two options; it can redeem or repurchase the 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 than 50% of the outstanding shares. A majority shareholder can dominate voting and exercise heavy influence over the direction of the company.
Repurchases and Redemptions
Repurchases are when a company that issued the shares repurchases the shares back from its shareholders. During a repurchase or buyback, the company pays shareholders the market value per share. With a repurchase, the company can purchase the stock on the open market or from its shareholders directly. Share repurchases are a popular method for returning cash to shareholders and are strictly voluntary on the part of the shareholder.
Redemptions are when a company requires shareholders to sell a portion of their shares back 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 set call price, which is the price per share that the company agrees to pay the shareholder upon 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 cost per share by buying them from shareholders through a stock repurchase. The company might offer, as an incentive, to repurchase the shares at a higher price than the current market, 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 issued redeemable preferred stock with a call price of $150 per share and has chosen to redeem a portion of them. However, the stock is trading at $120 in the market. The company's executives might choose to repurchase the shares rather than pay the $30-per-share premium associated with the redemption. If the company is unable to find willing sellers, it can always use the redemption as a fallback.
Conversely, if a company currently pays a 3% dividend rate on shares outstanding but has redeemable shares outstanding that carry a higher dividend rate, the company might elect to redeem the more expensive shares, with the higher dividend rate. One advantage of issuing redeemable shares is that it gives a company flexibility if they choose to buy back shares at a later date.
Companies can sometimes buy and sell stock like investors. If a company's executive management believes their stock is undervalued, they may choose to buy back shares at the perceived-discounted price. If the stock price appreciates in the future, the company has the option of issuing shares at a higher price per share, earning a gain from the sale when compared to the original repurchase price.
The Bottom Line
A repurchase involves a company buying back shares, either on the open market or directly from shareholders. Unlike a redemption, which is compulsory, selling shares back to the company with a repurchase is voluntary. However, a redemption typically pays investors a premium built into the call price, partly compensating them for the risk of having their shares redeemed.