What is Share Buyback and Why do Companies Buyback their Own Shares?
Share buyback or share repurchase is a mechanism by which publicly traded companies can purchase their own shares from existing investors – either directly (through a tender offer) or from a secondary market. It is often seen as a tax-efficient way to reward existing investors and return excess cash to them. In fact, in recent times, many companies have preferred to take the avenue of share buyback over dividend payouts.
While the offer generally stands for all investors, an investor is under no obligation to sell all or a portion of their ownership in the company. However, to make the deal more lucrative for investors, companies typically offer to buy back shares at a premium (i.e. at a price higher than the prevailing market price of these shares).
Let us now see how share buybacks work.
Companies generally declare a share buyback to repurchase a portion of their outstanding shares from existing investors. By using this mechanism, a publicly listed company can reduce the number of shares outstanding in the market and force the earnings per share (EPS) to climb. A higher EPS then increases the price of the shares remaining in the market, thereby acting as an incentive for shareholders to offload some or all of their shares.
The shares purchased could either be cancelled, held privately for future redistribution, issued to employees, or offered to strategic investors.
Share buyback reduces the net cash available to a company, which gets reflected on its balance sheet. However, since the value of outstanding stocks increases, it improves the company’s financial standing. Similarly, it reduces the shareholders’ equity, calculated as the total assets of a company minus its total liabilities. This means that the same amount gets reduced from the liabilities side of the company’s balance sheet, improving its financial position.
Let us understand the concept of share buyback better with a simple example. Let’s say a company A has ₹1 Crore in excess cash and 10 Lakh outstanding shares. Let’s also assume that the company’s board decides to buy back 2 Lakh shares from the open market and earmarks ₹30 Lakh for the same.
Once the share buyback exercise is complete, the total cash remaining with the company will be ₹(1 Crore – 30 Lakh) = ₹70 Lakh and the shares outstanding in the market would be (10 Lakh – 2 Lakh) = 8 Lakh.
Generally, this will increase the earnings per share of the stock (=a company’s profit÷total number of outstanding shares) and in all likelihood could elevate the price of the stock as well.
1. To Reduce Liquidity
Companies sitting on excess cash and having no new expansion plans can often opt for buyback of shares, especially when the market is on the upswing. These companies usually have robust financial fundamentals, and instead of keeping the extra cash in bank accounts, they use their excess cash reserves to regain the outstanding shares available in the market, which can increase the value of the existing shares in the market. Many investors see it as a sign of a company’s strong financial health in the short to medium term and may be drawn to invest more.
2. Tax Benefits
Another reason why companies go for buyback of equity shares is the tax benefits associated with this mechanism. All the proceeds gained from a share buyback exercise is termed as buyback income, which is not taxable. Stock buybacks were only subjected to Dividend Distribution Tax (DDT), which was abolished in the Union Budget 2021-22.
3. Indicates Company’s Profitability
Whenever a company opts for repurchasing shares, the Earnings per Share (EPS) of the company improves. It typically tends to increase the market valuation of outstanding shares and improves investor confidence.
Whenever a company has too many shareholder groups, it may become a difficult task to manage them. It can lead to delays in decision making as well as power struggles. All these could hamper the smooth functioning of the organisation.
The promoter group usually goes for share buybacks to consolidate their grip over the company. Sometimes, shares may also be bought back and then offered to strategic investors, who the company promoter or board wants to bring on board.
Companies often use share buyback as an alternative and more tax-efficient route to reward shareholders. While dividend payout is another option many companies use to incentivise investors, share repurchase can be a better option since it is more flexible.
Moreover, share buyback can be used as a tool to prevent distress or panic sell by shareholders when the market underperforms. If a company can foresee such a situation, it could buy back its shares to protect its share price from falling steeply.
There are different strategies used by companies to maintain or expand their market capitalisation. Repurchasing shares is one such strategy that a company uses to consolidate shares under one strategic group of investors or promoter, improve shareholder confidence about the company’s financial security and future, and increase market valuation.
Also Read
A buyback of shares, more often than not, affects a company’s market valuation and financial standing positively. Whenever a company opts for stock buybacks, it reduces the number of outstanding shares and generally increases the price of its shares. It will also increase the earnings per share for the company, which usually sends a positive signal about a company’s value and profitability.
Share buybacks also positively affect the price-to-equity (P/E) ratio of companies. This metric allows investors to get an idea about the relative valuation of the company. It measures the current share price relative to the earnings per share of the company. A lower P/E ratio could indicate that the stock is fairly priced and has a higher growth potential.
1. Poor Use of Company’s Cash Reserve
Stock buybacks could help companies increase their share prices in the short term. However, it may sometimes prove more useful to sit on excess cash because it can be used for other productive purposes, such as Research and Development (R&D) or exploring new growth opportunities in the market. Excess cash can also be used to create a buffer or a contingency fund to fight off market downturns and economic crises.
2. Debt-oriented Buybacks
Many companies, during times of financial distress, go for stock buybacks that trigger debt. To initiate a share buyback, they have to offer the shareholders a higher price than the prevailing market prices. To proceed with their buyback plan, they may have to depend on borrowing heavily from the market. This could make these companies overleveraged and debt-ridden.
3. Conceals Compensation to Executives
Organisations use stock buybacks as a garb to conceal how compensation to executives affects the share count. Companies offer various incentives to their managers, such as ESOP, and this offering dilutes the privileges of existing shareholders.
4. Could Lure Investors into a False Sense of Optimism
A company can use share buyback to increase its earnings per share (EPS) by reducing the number of outstanding shares, without actually increasing its earnings. This could sometimes indicate that the company’s financial standing or fundamentals are strong or its outlook is positive, when the actual situation could be very different. So, shareholders should not use EPS as the only metric to evaluate a company’s performance. While it could benefit short-term investors, it can hurt the interests of long-term investors since it can inflate share prices in the short-term, without changing the company’s underlying fundamentals.
EPS increases as a result of share buybacks. When companies repurchase shares, the number of outstanding shares in the market reduces. Earnings per share are computed by dividing net profit by total outstanding shares; hence if the number of outstanding shares reduces, the EPS will increase.
2. On Financial Statements
The impact of share buyback needs to be considered in different types of financial statements, such as cash flow statements and statements of retained earnings. While the cash reserve shrinks, increase in shareholder equity could reduce the same amount from the liabilities side of the company’s balance sheet.
3. On the Company’s Reputation and Investment Prospects
Usually, a share buyback is greeted with optimism from existing investors. It is a sign of financial robustness and creates trust in the minds of the company’s stakeholders. It can improve the reputation of the company and attract new investors.
When a company exercises its stock repurchase option, the market usually views it positively. It is generally interpreted as a sign of the company’s financial robustness. It could also be an indication of a strategic investment, partnership, or expansion – which, when viewed from a macroeconomic perspective, could be an indication of economic growth and stability.
A share buyback increases the earnings per share and often the market value of a share. However, it need not lead to an actual improvement in the company’s profitability or sales.
There is no one right answer for this. While most investors and market analysts see it as a positive development, there are critics as well.
Here’s why share buyback can be a good thing:
- Could signal that the company management is bullish on their future prospects. This can enhance investor confidence as well.
- It can help change the capital structure of the company. It could indicate that the company wants to reduce its exposure to equity and increase its reliance on debt, which can have long-term benefits as the cost of debt financing is generally lower than equity financing.
- It could help the company consolidate fragmented power centres and give back control to one group – which could be the promoter or other strategic investors. This could improve the speed of decision-making and implementation of policies.
- Open-market buybacks usually increase the price of a company’s outstanding shares, which helps it improve its financial position.
- It could create a safety net for the company’s share price, especially during times of financial distress, preventing it from falling below a certain level.
However, there could be some drawbacks as well:
- It could create a false sense of optimism among investors and the company management, masking actual problems in the company’s fundamentals, if there’s any.
- It may not lead to an actual increase in the company’s earnings even though there could be a temporary share price hike.
- It can create scope for malpractices, such as insider trading and manipulation of the stock price to create short-term gains for key stakeholders.
| Dividend | Share Buyback | |
| Beneficiary | All existing shareholders are eligible to receive dividend payments. | Only shareholders who are surrendering their position can claim these benefits. |
| Shares | The number of outstanding shares is unchanged. | In case of share buyback, the outstanding shares reduce. |
| Frequency | Dividends are generally more frequent than share buybacks. They are paid either on a monthly, quarterly, or annual basis. | A stock buyback is rare and occurs only when the company believes its shares are undervalued or it wants to regain strategic control. |
| Taxation | Dividend payouts, in excess of ₹5,000, attract TDS at 10%. For payouts below ₹5,000, an investor has to pay tax as per the applicable income tax slab rate. | Investors do not incur any additional tax on share buyback proceeds. |
Final Word
Some say share buyback is overrated. Many others feel that it is a tax-efficient mechanism to reward investors, boost investor confidence, and increase a company’s market value and standing. We reserve our judgement on the subject and leave it up to you – the reader – to decide how you want to view it.
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FAQs
No, a company cannot force their shareholders to take part in these buyback programs. Shareholders are free to make a decision whether they want to surrender their shares or not.
Stock buybacks create value for the shareholders. They can choose to sell their shares to the company and earn higher returns on their investment. This also offers them an opportunity to exit as the shareholder of a company.
In India, buyback of shares has been discussed under the Companies Act 2013. Various provisions of this act regulate share buybacks. Section 69 deals with the treatment of proceeds of stock repurchase, whereas section 70 stipulates conditions under which companies cannot go ahead with a repurchase.
The sources of funds from share buyback includes securities and the premium account or reserve account. No buyback can occur from an earlier issue of similar shares.
A share buyback round increases the percentage of ownership held by each of the existing shareholders by reducing the total number of outstanding shares available for trade in the exchanges.
A company, its management, and investors – all can benefit from a stock buyback. That’s because companies usually offer to buy back shares at a higher price than the prevailing market rate, which means more profit for investors. The company, by reducing its earnings per share, can also increase its share price, which will improve its overall market value and could attract potential investors.
A stock buyback lowers a company’s outstanding shares and increases its earnings per share. It reduces shareholder equity and could help consolidate fragmented ownership and remove multiple power centres.
When a company announces a share buyback plan, all eligible shareholders, can either fill up a physical or online share tender form or use an online trading portal to participate. Please note that only shares held in your demat account before the record date, as announced by the company in its buyback notice, can be tendered for buyback.
To tender shares for buyback, you will either need to fill up a physical form, which the company could send you via courier or which you could receive from your stock broker. You could even use your trading portal to indicate the number of shares you want to tender for buyback. Once the process is over, shares will be debited from your demat account and the sale proceedings will be credited to your linked bank account.
Typically, a share buy back is followed by an increase in the share price of the company. That is because it is generally viewed as an indication from the company management that it is confident about its future prospects and growth.
Generally, share buybacks are believed to be a more tax-efficient alternative to dividends.
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This article has been prepared on the basis of internal data, publicly available information and other sources believed to be reliable. The information contained in this article is for general purposes only and not a complete disclosure of every material fact. It should not be construed as investment advice to any party. The article does not warrant the completeness or accuracy of the information and disclaims all liabilities, losses and damages arising out of the use of this information. Readers shall be fully liable/responsible for any decision taken on the basis of this article.
