A share buyback is a re-acquisition process by which a company or organisation buys back its own shares from its existing investors. Companies mainly do this to re-acquire the number of outstanding shares available on the exchanges. This is a tax-efficient way to reduce the excess liquidity of a company.
Share buybacks generally require companies to repurchase shares allotted to investors. As shareholders are not obligated to sell their shares back to the companies, these repurchase offers are at a higher level than prevailing market prices. Read on to know its importance and how it affects the value of a company.
A share buyback is a mechanism by which companies repurchase their shares from existing shareholders. It happens either through open markets or a tender offer. In the case of open market offers, listed companies buyback shares through secondary markets by quoting higher prices than prevailing rates.
On the other hand, in a tender offer, shareholders directly sell their shares back to the company at the specified price and within a given date. But, what could be the reason for share buyback? Scroll down to find out.
Here are some of the reasons why companies generally go for buyback of shares:
1. Reduce liquidity
Companies with excess liquidity and no new expansion plans opt for buyback of shares. These companies have robust financial fundamentals, and instead of keeping extra cash in bank accounts, they use their excess cash reserves to regain the outstanding shares available in the market.
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 share buybacks is termed as buyback income, which is not taxable. Stock buybacks were only subjected to Dividend Distribution Tax (DDT), which has been abolished as per 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 presents a profitable picture of their valuation; moreover, it sends a positive signal to prospective investors about the rise of the stock prices.
4. Strengthens a company
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 between shareholder groups. All these will hamper the smooth functioning of the organisation.
The promoter group usually goes for share buybacks to consolidate their grip over the company. It also leads to the orderly functioning of the organisation.
Various companies go for share repurchases as an alternative method of rewarding their shareholders. Usually, companies provide regular dividends to these shareholders, but a stock buyback is more flexible and efficient than dividend payouts.
Many companies choose to buyback shares over offering dividends as the former helps in preserving stock prices. In times of financial distress, if companies reduce or stop dividend payments, it sends a wrong signal to investors, who consequently indulge in heavy sell-off.
On the other hand, a stock buyback at this point is the better option as it protects the prices of stock from falling steeply.
There are different strategies that every company adopts to hold their market capitalisation. Repurchasing shares is one mechanism that is tax effective, offers greater control and maintains the market valuation of the company.
A buyback of shares does affect the value of a company by sending a positive signal to prospective investors. Whenever they go for stock buybacks, it reduces the number of outstanding shares and removes excess cash on a company’s balance sheet.
The shares that companies repurchase are either cancelled or kept as treasury shares. As the number of outstanding shares gets reduced, earnings per share or EPS of the company improve. A higher EPS sends a positive signal about a company’s value and profitability.
Similarly, share buybacks also positively affect the price-to-equity ratio of companies. This metric allows investors to get an idea about the relative valuation of the company. Therefore, investors analyse stock buybacks and get an idea about the company’s performance.
Here are some disadvantages of stock repurchases:
1. Poor cash use
Stock buybacks help companies with a short-term increase in their share prices. However, organisations could have used these excess cash reserves for other productive plans like Research and Development (R&D) or creating a contingency fund. These may not give overnight results, but their importance can be felt in the long term.
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, which can induce huge debts.
This is not a sustainable strategy for the companies as higher debt increases their liabilities which can further exaggerate their financial misery.
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.
A share buyback impacts several aspects of a company, some of which are as follows:
1. Earnings per share
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 gains by total outstanding shares; hence if stock prices fall, EPS will increase.
2. Financial statements
A share buyback transaction finds its place in various financial statements, which includes cash flow statements and statements of retained earnings. Moreover, a reduction in cash due to repurchase will affect the balance sheet as well, inducing a lower value of total assets.
Apart from these, the number of equity shares on the liabilities side will also see a fall.
3. Company’s portfolio
Every share buyback is positively greeted by prospective investors. It is a sign of financial robustness and creates trust in the minds of potential investors. Therefore, investors look for upcoming buyback of shares to plan their investments. All these help in enhancing a company’s reputation and overall portfolio.
A stock repurchase option exercised by a company indicates the financial robustness and profitability of the company. It also serves as a signal for something huge happening in the company; it may be a merger or acquisition or launch of a new product, etc.
A share buyback indicates an imminent increase in the price of stocks; therefore, it is an indication for prospective shareholders to take a plunge and existing shareholders to increase their outlay. It also reflects efforts by companies to reduce the erosion of capital during times of crisis.
A few differences are:
|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 more frequent than share buybacks. They are paid either monthly or annually.||A stock buyback is rare and occurs only in specific instances.|
|Taxation||Dividends received by shareholders are taxed at three levels.||Share buybacks have no tax liabilities.|
Companies can decide to buy back their shares due to various reasons. Existing investors also wait eagerly for these offers as it gives them a higher return on their investment. This detailed guide about what is a share buyback, its impact and its reasons will help you make an informed decision.
Ans: 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.
Ans: 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.
Ans: 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.
Ans: 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.
Ans: 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.
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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.
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