What is share repurchase?
To understand the effect of a buyback on the share price, it’s essential first to understand the concept of share buyback.
Share buyback has been increasing in India at a steady rate since 2016. A buyback is a process by which a company repurchases a percentage of its outstanding shares from the shareholders. The company purchases its own shares from the marketplace. It is a common way for companies to return wealth to their shareholders. When a company buys back its shares, it means it is confident about its future earnings growth. Factors like Earnings Per Share (EPS) experience a positive impact from a share repurchase.
Why share repurchase?
Many companies try to reward their shareholders through a steady increase in dividends and regular share buybacks. There are several reasons why a company initiates a share buyback. Here are seven of them:
1. It could have excess cash on its balance sheet.
2. It might not have an alternate investment option.
3. It might opt for repurchase as a confidence-building measure to check the fall in prices.
4. It may want to reduce the market cap, thereby increasing EPS strategically.
5. It may want to lower dividend payout to shareholders, thereby resulting in lower taxes for the company.
6. It may want to get a higher return on equity (RoE), leading to higher valuations.
7. It may want to increase its undervalued stock or to prevent a hostile takeover.
What’s the effect of buyback on share price?
A share repurchase reduces a company’s outstanding shares. Hence, it has a direct impact on EPS. This happens because the net income tends to remain the same. The total number of outstanding shares reduces post repurchasing.
Secondly, share repurchase has an impact on the financial statement of a company. This leads to reducing a company’s cash holding and total assets in the balance sheet. There would also be a reduction in shareholder equity. This, in turn, improves performance metrics such as Return on Equity (RoE) and Return on Assets (RoA).
Thirdly, companies that have a lot of faith in their prospects opt for share repurchase. This, in turn, reflects later in their portfolio. Share repurchase often has a positive impact on its market reputation and its share value.
Fourthly, companies that opt for share repurchase can easily enhance their EPS significantly. Companies with steady EPS are high in demand from investors as they tend to have high growth and earnings potential. It is believed that companies that repurchase shares from shareholders have a significant market presence and robust pricing power. Share repurchase helps create a positive image of the company in the market. Hence, investors are willing to pay a premium for stocks with steady EPS growth. This move in-turn results in their P/E multiple expanding over time.
Dividend vs share buyback
Dividend and share buyback are both ways for companies to return cash to shareholders. While dividend involves current payment, buyback is about future payment. When a company offers dividends, the total number of shares remain intact. However, in the case of share buyback, there is a reduction in the total number of shares.
A dividend is meant for existing shareholders while share buyback is meant for surrendering shareholders.
While a dividend is relatively an old concept in India, share buyback is a relatively new one, when it comes to rewarding shareholders. When it comes to dividend, companies tend to declare a reward in the form of a regular, annual, special, one-time manner. In the case of share buyback, there’s no such manner.
Also, when it comes to tax treatments, both dividend and share buyback are different. In the case of dividends, there is a three-way tax implication. On the contrary, share buybacks were previously treated as capital gains, and hence, it came under the capital gain tax. However, after 2019, investors were not required to pay such a tax on their earnings through a stock buyback. The companies opting share buyback are entitled to deduct 20% of the generated profits as DDT before disbursing them to the shareholders.
Though most blue-chip companies buy back shares regularly, investors should do their due diligence well before making any investment. They should ideally watch out for companies that offer lucrative or expanded buybacks. Amateur investors could refer to the S&P 500 Buyback Index to identify companies that have been aggressively buying back their shares.
Stock buybacks are considered to be a definite way to build one’s net worth. To get a broader picture, investors should become more familiar with its impact on the company, share prices and future earnings.
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