What is Buy Back of Shares? Definition, Reasons and its Impact
Understand what buyback of shares is and why it happens in the stock market, the reasons behind buying back shares, and their impact.
Stock repurchases are surprisingly divisive among investors. Some investors regard them as a waste of public money, and others see them as an excellent way for stockholders to generate tax-advantaged returns. Both critics and supporters have valid points, but who is correct?
The bottom line is that well-executed stock repurchases are among the best and least-risk ways to create value for shareholders. However, not all businesses carry them out correctly.
Continue reading to learn what is buyback of shares is and how it adds value to a company, as well as its benefits and drawbacks.
What is the buyback of shares?
A share buyback is the purchase of a company's shares: It must be cancelled when it buys back shares. If a company has enough cash, it may decide to buy it's stock. A corporation cannot purchase its stock.
What are the different types of buybacks?
Buybacks are classified into two types: open market and tender offer.
Companies may repurchase shareholdings on the open market at predetermined intervals or whenever management believes it is the most acceptable use of capital.
The business offers to buy back its shares in a tender offer. This offer is frequently at a premium cost than the open market price of the shares. The Securities and Exchange Commission is in charge of overseeing all tender offers (SEC).
A third party seeking to gain control of the company may also make a tender offer. The transaction, in this case, is a third-party tender offer, not a buyback.
Read on to learn more about these!
Top reasons for buyback of shares
The following are some of the factors that may prompt a company to initiate a stock buyback:
1. To indicate that a stock is underpriced
If a company's management chooses to believe that its shares are undervalued, it may decide to purchase back some of its shareholdings from the market to raise the price of the outstanding shares.
2. To distribute cash to shareholders with a great deal of flexibility in terms of both amount and time frame.
Dividend payouts do not give the company's organisations leeway because they must be paid on specific dates and to all common shareholders. On the other hand, stock buybacks generally provide such a high degree of flexibility because they do not define the quantities that must be paid or the dates when the transactions must occur.
3. To benefit from tax breaks
In countries where the capital gain tax rate is lower than the dividend tax rate, stock buybacks can be a fantastic option for dividend cash payments.
4. To absorb growth in the number of shares outstanding as a result of stock option exercise
Companies that provide stock options as part of their employee compensation packages frequently initiate stock buybacks. The practice is justified because when employees work out their stock options, the number of outstanding shares increases.
5. As a means of preventing a hostile takeover.
As a defence strategy against a hostile takeover, a target company's management can buy back many of its shares from the market. The defence strategy's goal is to reduce the acquirer's chances of obtaining a majority stake in the target company.
Advantages and Disadvantages of Buyback of Shares
Share buyback benefits
The share repurchase programme is adaptable. Unlike cash dividends, it is carried out over a long period. It can be cancelled or modified based on their requirements. The company is under no obligation to carry out the repurchase programme. The shareholders are also not obligated to sell their shares.
The stock buyback will be taxed under the capital gains tax bracket. Some countries have lower capital gains tax rates than dividend tax rates. As a result, investors prefer share buybacks over cash dividends when deciding on dividend types in such countries.
Improved Financial Ratios
Because profit is unaffected by a decrease in the number of shares, higher ratio increases such as EPS, DPS, ROE, and so on will result. As a result, profitability per share will increase.
1. Valuation Judgment Error
Though leadership has greater access to company information, there is still a chance that they will overestimate the company's value. If the buyback is undertaken to support the underpricing, but the company overstates the prospects, the entire buyback process will be rendered ineffective.
2. Unrealistic Image Created Using Ratios
Some ratios, such as EPS, ROA, and ROE, are boosted by share buybacks. This increase in proportions is due to a decrease in shares outstanding. Profit growth is not occurring organically. The buyback will be optimistic.
Methods of Stock Purchases
When sharing repurchases, companies usually use one of three methods.
Share repurchase on the open market
The "open market repurchase" is the most common of these methods. When using this method, the business makes an official public statement that it will be buying back its shares from the open market over time as market conditions dictate.
The share repurchase programme does not end with such a single transaction. As a result, open market repurchases can take months or years to complete.
Because the volumes implicated in this buyback method are significant, it significantly increases the long-term demand for several shares. It is also likely to influence the stock price during the ongoing repurchase operations.
Buyback of Fixed-Priced Tender Shares
The "fixed price tender" is a less common method of corporate share repurchase. The book value, the number of shares repurchased, and the offer duration are all pre-determined and pre-specified by the company in a fixed price tender.
And all of this information is made public as part of a mandatory information release. Shareholders who wish to sell their shareholdings at the specified price convey their desire.
If the erstwhile level is trim, the offer's duration is extended to allow more shareholders to convey their interest.
Dutch Auction – Share Repurchase
The price of the rebuy is "discovered" in this method, just as it is in the case of an IPO.
First, the company specifies the price range. Then, shareholders state one‘s pleasant price point within the specified range.
The company then constructs a demand curve based on the inputs from the interested stockholders. The company determines the lowest price with which it can purchase the required amount of shares using the demand curve.
The company then purchases the shares from the shareholders who tabled at or below the determined price.
How Will the Buyback Affect the Value of Your Company?
Contrary to popular belief, buybacks do not add value and increase earnings. After all, the company spent cash on buying those shares, and shareholders will adjust their market values to reflect the decreases in cash and shares, effectively cancelling any earnings-per-share impact. If the only reason for buybacks were to increase earnings per share, they would not affect the value—which, as we've seen, is not the case.
A buyback, also recognised as a stock repurchase, occurs when a company sells its outstanding stock to reduce the number of free-market shares. Corporations buy back shares for various reasons, including increasing the value of the company's assets by lowering supply or preventing other shareholders from gaining control of shares.
Direct deals with large owners or shareholders, open market potential, fixed-price bids, and the Dutch auction deal are all used to buy back shares. The main advantages of repurchasing shares are their adaptability. Shareholders may or may not wish to sell back their shares, and the company may approve or cancel repurchases. Other benefits include tax breaks and business signalling opportunities. To make an informed decision, shareholders must verify that exchanges are valid and consider the reasons for transactions.
Q1. What exactly is a share buyback?
A buy-back is a corporate action where a company purchases its existing shareholders' shares at a price higher than the market price. When it buys back shares, the amount of stocks decreases.
Q2. Is it possible to repurchase your stock?
To begin, it is possible to repurchase shares and hold them as treasury stock on the company's balance sheet. The company uses this for treasury operations. Second, you can buy back the shareholdings and extinguish them, reducing the number of shares outstanding to that large extent.
Q3. Why does a company repurchase shares?
Companies buy back their stock primarily to create value for their shareholders. In this case, value refers to an increasing share price. It works because whenever there is a requirement for a company's shares, the stock price rises.
Q4. What happens during a share buyback?
A stock buyback usually increases the price of the outstanding residual shares. This is a basic supply-and-demand economy: there are fewer exceptional stocks, but the company's value has not changed, so each share is worth more, and the price rises.
Q5. Is a buyback beneficial to investors?
Share buybacks can add value to investors in various ways, including Repurchasing and giving cash back to shareholders who want to get out of the investment. All else being equal, a buyback allows the company to increase earnings per share. The actual earnings pie divided into fewer slices is worth a more significant portion of the profits.