Companies buy back shares they have earlier issued in the market using cash. This method of repurchasing shares is done for several reasons, including but not limited to undervaluation of a stock.
Companies may opt for buybacks if they have extra cash or no particular investments or requirements. By reducing share numbers, the earnings per share or EPS is lowered for the shareholders who are with the company and their returns on equity gets a boost.
Many companies take up direct buyback of shares in India from their shareholders. This is one of the buyback of shares methods wherein the company negotiates share prices with some big shareholders and buys from such individuals. A company buys back shares from shareholders but there are several other transaction methods when it comes to buyback of shares in India. The other methods are below:
Shares need not necessarily be bought back from the individual shareholders. One of the buyback of shares methods is via the open market. The shares buyback is carried out over a lengthy period because usually a huge number of shares are bought. Also, the company can cancel the repurchase programme whenever it chooses to.
Fixed price tender offer
In this method of buyback of shares in India, the company approaches shareholders via a tender. Shareholders who wish to sell their shares can submit them to the company for sale. As the name suggests the price is fixed by the company and is over and above the prevailing market price. The tender offer is for a specific period and is generally a short time.
Dutch auction tender offer
This is much like the fixed price tender but instead of a price that the company allocates in the fixed price tender, here the company provides a range of prices that shareholders can pick. The minimum price of the stock is higher than the market price prevailing then.
The open market and fixed price tender are used more by companies.
So, why does buyback happen?
As mentioned earlier, buyback of shares methods may indicate undervaluation of stock. Companies buy back some shares they issued earlier to increase the earnings per share and price of shares that remain.
Another reason for shares buyback is that it prevents any takeovers or mergers. If some other firm is planning to buy a majority portion of shares in the market, then the company can buy back its shares and own them again.
Dividend vs share buyback
Shares buyback is taxed under the category of capital gain taxes. This is a greater tax efficient method than dividends. Dividends are specific amounts per share that are paid to shareholders. Dividends are distributed to every shareholder while buyback of shares is only for shareholders who opt for it. When it comes to dividends, companies would have to pay dividend distribution tax or DDT with the government before they disburse profits. Individual shareholders also have to pay extra tax if the income from dividends is over Rs 10 lakh.
When it comes to buyback of shares, rate of tax is dependent on the period for which the security is held. If shareholders give up their shares for a buyback process after a year of holding them would have to pay taxes at 10 per cent rate on their earnings. If the sale is made earlier than a year, short term capital gains are taxed at 15 per cent. For the company, share buybacks may look like a preferred option.
What are the buyback modes available?
– Companies could use free reserves for shares buyback. The capital redemption reserve account is one such that is maintained by a firm. The account deals with redeemable shares. When a company buys back shares from free reserves, the amount equal to share nominal value would need to be transferred to the capital redemption reserve.
– Another mode of buyback is securities premium account. This is the additional money that has been gained when a company that sells shares over their fair value.
– Companies cannot make use of any proceeds that have come through equity shares issuance to repurchase equity shares. Companies can use preference shares or proceeds from debenture issues to buy equity shares.
The buyback of shares methods include directly negotiating with large individual shareholders, open market, fixed price tender offer and Dutch auction tender offer. The biggest advantages of buying back shares lie in the flexibility of the process. Shareholders have the choice of selling back or not and the company is also free to take up or cancel repurchase. The tax benefits and signaling opportunity it provides for companies are other advantages. Shareholders need to check if buybacks are good for them and understand reasons for buyback to make an informed decision.