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:
- Increasing Shareholders’ Wealth: According to the law of demand and supply, if there are less number of shares in the market and the demand of the shares are increasing, then the price of the shares will rise. This will result in increasing the wealth of the existing shareholders.
- Higher Price of Share: Buying back of stock means that the company earnings are now split among fewer shares, meaning higher earnings per share (EPS). Higher earnings per share generally command a higher stock price.
- Transferring Surplus Cash to Shareholders: Buying back stock allows a company to pass on extra cash to shareholders without raising the dividend. If the cash is temporary in nature, it may prove more beneficial to pass on value to shareholders through buybacks rather than raising the dividend.
- Tool for Financial Re-engineering: In the case of profit making, high dividend-paying companies whose share prices are languishing, buybacks can actually boost their bottom lines since dividends attract taxes. A buyback and the subsequent neutralization of shares can reduce dividend outflows, and if the opportunity cost of funds used is lower than the dividend savings, then the purpose of buy back is served.
- Increasing Investors’ Confidence in Management: It might enhance the confidence of its investors on the company’s board of directors, as these investors know that the directors are ever willing to return surplus cash if it’s not able to earn above the company’s alternative investment or cost of capital.
- Avoiding Takeovers: Buying back stock uses up excess cash. The returns on excess cash in money market accounts can drag down overall company performance. Cash rich companies are also very attractive takeover targets. Buying back stock allows the company to earn a better Return on excess cash and keep it from becoming a takeover target.
- Psychological Effect: When a company purchases its own stock, it is essentially telling the market that they think that the company’s stock is undervalued. This can have a psychological effect on the market.
- Tax Benefits: Exemption is available only if the shares are sold on a recognized stock exchange and if securities transaction tax (STT) on the sale has been paid. In a buyback scheme, neither does the sale take place on a recognized exchange nor is the STT paid. So, the shareholder will have to pay income tax on long-term capital gain on the buyback, after deducting the acquisition cost of the shares plus the benefit of indexation from the year of purchase to the year of buyback. On the resultant gain, the tax would be 20% plus the applicable surcharge, if any, plus 3 % education chess or we may also work out the tax at 10% of the gain without considering indexation. The tax liability will be limited to the lower of the two calculations.
- Stock buybacks also raise the demand for the stock in the open market. Since the company is competing against other investors to purchase shares of its own stock the demand is increased, which leads to increase in the prices. Characteristics of
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.