What if you had Rs 500 with you to spend for shopping? Just as you were getting ready to step out for retail therapy, your plans get derailed for multiple reasons. You shift focus from spending to saving. But even after saving you may have excess funds. What do you do with it? One way to do it is to pay back your friends to whom you owe money. This is how a company share buyback works too in the real world.
So, what happens when a company buys back shares?
Companies all across the world buy back shares for two main reasons: to rev up share price or to protect the company from a hostile takeover. A repurchase or buyback is likely to impact the value of outstanding shares, the dividend payment and organisational control. Companies tend to buy back shares when they have cash on hand, and the stock market is on an upswing.
A company also buys back shares to boost the value of the stock and to improve its financial condition. Often these shares are allocated for employee compensation or a secondary offering or toward retirement options. Or the stocks are reissued on stock exchanges at a later time.
How do companies buy back shares?
Majority of the company buyback takes place in the open market. Apart from this, buybacks also happen with a fixed price tender offer. This offer essentially invites shareholders to sell their shares at a specified offer price willingly. In this case, shareholders can decide whether to participate or not. Not enough shareholders may choose to sell their shares.
They also buy back shares through a Dutch auction. This is a method wherein the company will offer a price range at which they’d be willing to sell their shares. The buyback takes place at the lowest price, that allows the company to buy back the desired number of shares. All shareholders whose bids were at or below that price will receive the same amount for their shares.
Then there are private negotiations, wherein the shareholders permit the companies to buy back shares if the above options fail.
In case of Put options, the holders sell shares of their stock at a specified price before a pre-determined expiration date.
Advantages of share buyback
Share buybacks reduce the number of shares available in the market. They increase Earnings Per Share (EPS) on the remaining shares, benefiting shareholders. For companies loaded with cash, EPS helps as the average yield on corporate cash investments is barely more than 1%.
Also, when companies have excess cash, when they opt for buyback programs, the investors feel more assured. Investors feel more secured with the fact that the companies were using the money to reimburse shareholders rather than investing in alternative assets. This move in-turn supports the price of the stock.
When companies go for buybacks, they tend to reduce the assets on their balance sheets and increase their return on assets.
There are also tax benefits associated with buybacks. When excess cash is used to buy back company stock, shareholders have the opportunity to defer capital gains if share prices increase.
Whenever shares of a company trade at too low a level, it usually buys back shares. Companies could also leverage on buybacks when a recession hits the economy, a similar sort of crisis or in times of market correction.
Buyback increases share prices. Often a reduction in the number of shares in the market leads to a price increase. A stock trading is based a lot on supply and demand. Hence, a company can bring about an increase in its stock value by creating a supply shock through a share buyback.
Also, as we have mentioned earlier, companies tend to protect themselves from a hostile takeover by buybacks.
Disadvantages of share buyback
Share buybacks are often perceived to be ‘marketing gimmick.’ Investors need to be wary of this and not get into its trap. As companies sometimes pursue buyback to boost share prices artificially. Executive compensations in a company are often tied to earnings metrics. If earnings cannot be increased, then buybacks can superficially boost earnings.
Also, buybacks can often get misleading. When buybacks are announced, any share purchase tends to benefit short-term investors rather than long-term ones. This creates a false notion in the market about improving earnings. A buyback ultimately ends up hurting the value.
Some companies buy back shares to raise funds for reinvestment. According to experts, this is all good until the money is injected back into the company. The share buybacks are often not used in ways to grow the company. In many cases, share buybacks outnumber funds spent on research and development (R&D).
Buybacks tend to reduce a company’s cash reserves, thereby giving it less cushion in tough times. In the process, it makes its balance sheet look less healthy.
Stock buybacks are indeed a powerful way the companies can give back capital to shareholders. However, they are a less visible way than through dividends. By understanding how buybacks work, you could understand companies’ capital return plans better and can make more informed investment decisions.
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