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|Are share buybacks good or bad - An Analysis|
There are a number of ways in which a company can return wealth to its shareholders. Although stock price appreciation and dividends are the two most common ways in which companies return wealth to its shareholders, there are other useful, and often overlooked, ways for companies to share their wealth with investors. This article dwells upon one of those methods, which is termed as BuyBack of Shares and goes through the mechanics of a share buyback and what it means for investors.
Are share buybacks good or bad?
As it often happens in cases of finance, the question may not have a definitive answer. If a stock is undervalued and a buyback truly represents the best possible investment for a company, the buyback and its effects can be viewed as a positive sign for shareholders. However, if a company is merely using buybacks to prop up ratios, provide short-term relief to an ailing stock price or to get out from under excessive dilution, then it may not be successful and the whole process of buyback may go for a toss.
Meaning of “Buybacks”
A stock buyback, also known as a "share repurchase", is a company's buying backs its shares from the marketplace. Buyback is a reverse of the issue of shares by a company where it offers to take back its shares owned by the investors at a specified price; this offer can be binding or optional to the investors. We can think of a buyback as a company investing in itself, or using its cash to buy its own shares. As we all know that a company can't act as its own shareholder, repurchased shares are absorbed by the company, and the number of outstanding shares in
The market is reduced. As a result of which, the relative ownership stake of each investor increases because there are fewer shares, or claims, on the earnings of the company. In other words, stock buyback is the purchase of a long position by a company to offset a short position.
Reasons of Buyback of Shares
A company can go for buyback for many reasons but the most prominent and viable reasons are as follows:
Companies Going for Buyback Companies with some of the following characteristics may opt for a share buy-back scheme:
• Companies having high net surplus cash position.
• Companies having a low debt/equity ratio may go in for a share buyback so that the debt/equity ratio may be increased.
• Companies which do not have a high capital expenditure requirements in future.
• Companies having a high dividend yield.
• Companies, where the intrinsic value of the shares of the company is substantially higher than the market price of the shares of the company.
Methods of Buyback of shares can be done by the following categories of companies:
- Public Limited Companies or Listed Companies
- Private Limited Companies or Unlisted Companies Public Limited Companies or Listed Companies can go for buyback through tender offer or from open market through stock exchange.
1. Tender Offer
Shareholders may be presented with a tender offer by the company to submit, or tender a portion or all of their shares within a certain time frame. The tender offer will stipulate both the number of shares the company is looking to repurchase and the price range they are willing to pay (almost always at a premium to the market price). When investors take up the offer, they will state the number of shares they want to tender along with the price they are willing to accept. Once the company has received all of the offers, it will find the right mix to buy the shares at the lowest cost.
2. Open Market
The second alternative a company has is to buy shares on the open market, just like an individual investor would, at the market price. It is important to note, however, that when a company announces a buyback, it is usually perceived by the market as a positive thing, which often causes the share price to shoot up. Effects of Share Buyback When a company goes in for buyback of shares, there may be positive effects or negative effects on the shareholders and/or the company.
Effects on the Shareholders
When a company is having surplus cash, it can either pay it off as dividend or go for buyback of shares. When a company pays dividend they are entitled to pay dividend distribution tax. This cost has to be indirectly borne by the shareholders, who receive fewer dividends as a consequence of tax payments. Therefore by Buying back shares, a company gives surplus cash to the shareholder and saves tax for the shareholders.
Higher Proportion of Shares
When a company goes for buyback, the number of outstanding shares reduces. That means the proportion of investment of an individual investor increases in the company.
Higher Price of Shares
One of the reasons why a company goes for a buyback is that they think that their shares are undervalued. That is why they buy back shares at a premium or at a price that they think it should command in the market.
Effects on the Company
Change in the Shareholding Pattern
The shareholding pattern of the company may change, promoters and non-promoters shareholding can increase, decrease or remain unchanged.
Strengthened Financial Ratios
When a company decides to go for buyback, the financial ratios of the company are impacted to a greater extent. The ratios that are generally impacted are Return on Assets (ROA), Return on Equity (ROE), Earnings per Share (EPS) and Price Earnings Ratio (P/E).
Send Negative Signals
An announcement for buyback can send negative signals to the investors against the companies. A typical example is the Hewlett Packard (HP) case: The Company spent $ 8.2 billion to buy back 128 million of its shares from the market during the period November 1998 to October 2000. The aim of the company was to make opportunistic purchases of HP stock at attractive prices—in other words, at prices they felt that undervalued the company. Instead of signaling a good operating prospect to the market, the buyback signal drowned out more powerful contradictory signals about the company’s future which are an aborted acquisition, a protracted business restructuring, slipping financial results, and a decay in the general profitability of key markets.
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