What happens when a company does a buyback?

What Is a Stock Buyback?

When a public corporation spends funds to buy shares of its own stock on the open market, this is known as a stock buyback. This is something a firm might do to give money back to shareholders that it doesn’t need to fund operations or other investments.

A stock buyback is when a firm buys shares of stock from anyone who wants to sell them on the secondary market. Shareholders are under no obligation to sell their stock back to the company, and a stock buyback is accessible to all stockholders.

When a public company decides to do a stock buyback, it usually announces that the board of directors has approved a “repurchase authorization,” which specifies how much money will be allocated to buy back shares—or, alternatively, how many shares or what percentage of outstanding shares it intends to buy back.

How Buybacks Work

There are two ways to carry out a buyback:

Shareholders may be offered with a tender offer, in which they have the option to surrender, or tender, all or a portion of their shares at a premium to the current market price within a specified time frame. This premium is given to investors who offer their shares rather than keep them.
Companies may buy back shares on the free market over a long period of time, or they may have a formalized share repurchase program that purchases shares at predetermined dates or intervals.

A corporation can fund a buyback by taking on debt, using cash on hand, or using operating cash flow.

An increase in a company’s existing share repurchase plan is known as an extended share buyback. A company’s share repurchase strategy is accelerated by an enlarged share buyback, resulting in a faster shrinking of its share float. The market impact of a larger share buyback is proportional to its size. The stock price is likely to grow as a result of a big, expanded buyback.23

The buyback ratio is calculated by dividing the repurchase dollars spent over the previous year by the company’s market capitalisation at the start of the buyback period. The buyback ratio allows for a comparison of repurchase impact across different companies. It’s also a solid predictor of a company’s potential to return value to shareholders, as companies that buy back stock on a regular basis have historically outperformed the market.

6 reasons why a company could consider a share buyback

A number of corporations, particularly those in the technology industry, have announced share buybacks in the recent two years. Before we get into the specifics of buybacks in India, it’s important to understand how the worldwide repurchase scenario works. A firm can buy back its own shares in two methods around the world. To begin, the shares can be purchased and held as treasury stock on the company’s balance sheet. The corporation uses this for treasury activities. Second, you can purchase back and extinguish shares, reducing the number of outstanding shares by that amount. In India, the first approach is not permitted, and shares can only be purchased for the purpose of extinguishment.

So, why does a corporation repurchase its own stock? What motivates stock repurchases? The advantages for the stockholders and the company in question must be understood. The main point to consider is the value of share buybacks to shareholders.

1. Lots of cash but few projects to invest in

This is one of the most important factors to consider when a company decides to buy back shares. Indian IT firms such as Infosys, TCS, Wipro, and HCL Tech were typically sitting on billions of dollars in cash. Cash in the bank now has a cost, and it is better returned to investors. Reliance Industries, for example, may have billions of dollars in cash, but it also has significant telecom stakes. The majority of IT organizations have developed business models and have little room to invest in new projects. A fundamental rationale for share buybacks is that there is too much cash on the books and too few investment options.

2. Buybacks are a more tax-effective means of rewarding shareholders

After the Union Budget of 2016, when the government levied a 10% tax on shareholders whose annual dividend surpassed Rs.1 million, this advantage became more obvious in India. Dividends paid by corporations are now effectively taxed on three levels. Dividends are a post-tax appropriation, and then there is a 15 percent dividend distribution tax (DDT) when the firm pays out the dividend, as well as a 10% tax on shareholders. The promoters and large stockholders were the hardest hurt by the 10% tax. Buybacks, on the other hand, are more tax-efficient, even after accounting for the 10% LTCG tax implemented in the 2018 budget.

3. Theoretically buybacks tend to improve valuations of companies

When a firm buys back shares, the number of outstanding shares and the capital base are reduced. To that extent, it boosts the company’s EPS and ROE. If the EPS rises, the stock price should rise as well, providing the P/E remains constant. In practice, however, this does not always occur. When a company buys back shares, it is viewed as a company with limited future investment and growth prospects. As a result, because P/Es are typically driven by growth, such companies tend to quote at lower P/E ratios. As a result, while EPS rises, the reduced P/E tends to offset the impact on valuation.

4. Company can signal that the stock is undervalued

This is undoubtedly one of the most important signals that firms prefer to send out by buying back their own stock. The fact that the corporation is confident enough in its reserves to buy back its own shares suggests that it is undervalued in the eyes of its management. This is especially true in the case of equities that have sharply corrected despite no obvious fundamental issues. In these circumstances, it might be a good idea for the corporation to buy back shares in order to signify a price bottom. While the stock may not rise dramatically, it usually aids in the stock’s recovery.

5. Returns cash to the shareholders of the company

Shareholder activism by large shareholders and institutions is still relatively rare in India, but it is growing. In the United States, for example, powerful shareholders forced corporations like Apple to return more wealth to shareholders through buybacks. Many organizations have diversified into unrelated fields in the past simply because they were rich with cash. Instead, it could be a better idea to return the money to shareholders and allow them decide what to do with it. This type of shareholder activism is only now starting to emerge in India.

6. It can help the promoters to consolidate their stake in the company

There are times when promoters are concerned that their stake in a company will fall below a specific threshold. A buyback is an offer, and shareholders must decide whether or not to accept it. If promoters agree the buyback, their stake is preserved and they receive cash. Alternatively, they can grow their interest in the company by forfeiting the buyback. This is critical when the company is wary of other companies trying to take them over.

Why Do Companies Buy Back Their Own Stock?

The primary motivation for firms to buy back their own stock is to increase shareholder value. In this context, value refers to an increase in the price of a stock.

The way it works is that whenever there is a demand for a company’s shares, the stock price rises. When a firm buys its own stock, it helps to raise the price by increasing demand, resulting in increased value for all owners.

Maximizing shareholder value is one of corporate America’s top priorities. A corporation should always try to earn the maximum potential profits for its stockholders, according to this principle. Companies maximize value for shareholders by increasing the value of their stock and returning cash to shareholders in the form of dividends and share buybacks.

While dividend payments are likely the most popular method of returning capital to shareholders, stock buybacks have their own set of benefits:

Directly increase the value of a company’s stock. Any share repurchase program’s principal purpose is to raise the share price. The board of directors may believe that the company’s stock is cheap, making now a good time to buy. Meanwhile, investors may interpret a buyback as a sign of management’s confidence. After all, why would a corporation want to repurchase shares that it expects to lose value?
Efficient taxation. Dividend payments are taxed as income, although rising stock prices are not. Those who sell their shares back to the company will, of course, pay capital gains taxes, but those who do not sell will benefit from a higher share value and no further taxes.

Dividends offer less flexibility. Any corporation that starts a new dividend or boosts an existing dividend must commit to paying payments for the foreseeable future. That’s because reducing or eliminating the dividend in the future could result in reduced share values and disgruntled investors. In the meantime, because share buybacks are one-time events, they are far more adaptable management instruments.
Dilution with an offset. Companies that are expanding may find themselves in a talent war. If they give stock options to employees to keep them, the options that are exercised over time increase the total number of shares outstanding, diluting current shareholders. One method to counteract this is through buybacks.

How Stock Buybacks Affect a Company’s Value

Stock buybacks can have a significant impact on the key measures investors use to assess a public company since they remove cash from the balance sheet and potentially reduce the number of shares outstanding.

It’s vital to note that whenever a corporation buys back its own shares, they’re either canceled (which reduces the number of shares outstanding permanently) or kept as treasury shares by the firm. Many essential metrics of a company’s financial fundamentals are affected because these are not counted as outstanding shares.

Earnings per share (EPS) is a key indicator that is determined by dividing a company’s net profit by the number of outstanding shares. By reducing the number of outstanding shares, you can give a company a higher EPS, making it look to be operating better.

The price-to-earnings ratio (P/E ratio) helps investors assess a company’s relative valuation by comparing its stock price to its earnings per share (EPS).

Disadvantages of Stock Buybacks

Many critics of stock buybacks argue that they are an ineffective way for corporations to generate value for their shareholders. The following are some of the disadvantages of stock buybacks:

Inefficient use of funds. Stock buybacks may prioritize short-term increases in share price over other more profitable uses of resources, depending on a variety of reasons. Investing in R&D or just saving money for a rainy day may not assist share prices in the short term, but they may provide higher value in the long run.

Share buybacks financed by debt. Up to half of all buybacks were financed with debt in the years before the Covid-19 outbreak wreaked havoc on the economy. Low interest rates encouraged firms to borrow money to spend on share buybacks in the short term, boosting stock values. Many opponents believe this was a particularly naive strategy.

Stock prices of cash-rich corporations tend to be high. Following a period of strong success, some corporations conducting stock buybacks have amassed a cash reserve. Companies in this situation also have unusually high share prices, implying that they may be generating less value for shareholders than other cash uses.
Used to keep executives’ stock-based compensation a secret. Many public firms pay their executives in stock, diluting the capital of other shareholders. Executives may utilize share buybacks to disguise the impact of this type of pay on the company’s stock count.