Q. What should a small shareholder do in the event of a share buy back?  I want to keep my shares and utilise the dividend income; and if (as reported) this is seen as a means of “returning wealth to shareholders,” my overwhelming preference would be for it to be done by additional dividend income.  In the past I’ve not participated in buybacks; but I should appreciate your advice, spelt out for someone who has little financial expertise.

 A. A share buyback is the process of a company buying back its own shares from existing shareholders either in the marketplace (on market) or via direct offer (off market).  Often companies will do a combination of both.

Companies typically buy back shares to manage capital.  If the company buy “on market”, they will buy shares at the prevailing price at the particular time.  If they buy “off market”, they may make this offer to all shareholders or to a select few. In both cases, the company are required to disclose their intentions to the market.

A share buy back is generally an acknowledgement by the company that they cannot find a better use for capital than to buy back their own stock.

A company will buy back stock if they believe the prevailing share price is below fair value for the stock.

Companies may offer a buy back shares to reduce the size of the Company share registry by acquiring small parcels of shares. This reduces the administration costs of managing the share registry.

Buying back stock reduces the number of shares on issue and hence in theory should increase the earning per share.

Share buy backs can artificially support a share price and could mask a negative view of the stock.

If you have the option to accept or decline a share buy back offer, you will need to determine what is in your best interest.  If you accept the offer you may pay Capital Gains Tax.  If you don’t accept the offer, in theory the earnings per share should rise as the number of shares on issue reduces.  Accordingly dividends should rise hence increasing the taxable income to you.

Share buy backs are a tax effective means of distributing capital.  An “on market” buy back is capital in nature and shares bought back are subject to brokerage costs and Capital Gains Tax on the entire gain. “Off market” buy backs usually do not attract brokerage costs and may be structured to enhance the tax benefits.  For example, the company may split the payment to reflect a portion as a capital payment (hence subject to CGT) and the remainder as a Franked Dividend (hence subject to a Franking credits of 30%).  This is particularly attractive for those with shares in Superannuation or Allocated Pensions or who are typically in a low tax environment.

You will need to take a view on the future prospects of the company.  If you have a negative view or you feel there are better opportunities elsewhere in the market, accept a buy back offer if you feel it is fair value.  If you are positive on the prospects of a company and its capacity to grow into the future, and the buy back offer does not reflect this value, don’t accept an offer.

Follow Andrew on Twitter @AndrewHeavenFP.  This article was originally published in The Australian.