Buyback of Shares : Process, Reasons, Impacts & Example

What is Buyback?

A buyback is defined as an activity when a company repurchases its shares back from the shareholders through an open market or directly from the shareholders. The company executes a buyback of shares to reduce the availability of shares in the market, which reduces its supply and thus, the value per share increase. Further, a buyback increases the Earning-per-Share (EPS) helping the company to strengthen its market reputation. A company generally buys its share back at a higher price than a prevailing market price indicating a strong financial position of a company. A buyback might be looked at as an alternative reward offered to shareholders instead of high dividends. Sometimes, the motive behind buyback might be to regain the ownership and control of management. However, in common language, a buyback is re-purchasing the shares from the shareholders.

Geeky Takeaways:

• A buyback is a corporate action to repurchase its shares back from the shareholders by offering them a higher value than the prevailing market price.
• The buybacks are generally conducted to restrain the power and management control and to increase the Earning-per-Share (EPS) of the shares.
• A buyback may be also seen as a reward offered to shareholders and reflects a strong financial position of the company.

Process of Buyback

A company can opt for either “Open Market Operation” or “Tender Offer” to buy back the shares. The process of buyback involves several steps as discussed below,

1. Approval of the Board of Directors (BOD): The decision to initiate a share buyback begins with the approval of the company’s board of directors. A board of directors after evaluating the financial state, cash reserves, strategic goals, and impact of buyback on the company and shareholders approves the buyback decision.

2. Approval of Shareholders: As per the Local Legislature and Corporate Governance, a company may require the approval of shareholders before executing the process of buyback if it affects a significant amount of share capital.

3. Announcement: After obtaining all the necessary approvals, the company makes a public announcement about its intention of buyback. A company communicates key details such as the maximum number of shares to be repurchased, the duration of the buyback program, and the maximum price per share.

4. Selecting Method of Buyback: A company determines the method of buyback. The most common method of the buyback is “Open Market Operation” or “Tender Offer”. In an open market operation company buys the shares at a stock exchange where whereas in a tender offer, a direct invitation is sent to shareholders with a price quotation.

5. Implementation: The company executes the buyback according to the specified method. It may hire brokers to make open market purchases or directly approach shareholders in the case of tender offers. The company may repurchase shares over an extended period to avoid significant market impact.

6. Monitoring and Reporting: The process of buyback is continuously monitored throughout the buyback period. The updates are reported to shareholders and regulators. This ensures transparency.

7. Cancellation or Treasury Stock: The bought-back shares are held outstanding as treasury stock that might be canceled, reducing the total number of outstanding shares. A company may also reissue the treasury stock in the future.

8. Financial Reporting: The company reflects the impact of the buyback in its financial reports including an increase in Earning per Share (EPS), an increase in shareholder value, a reduction in outstanding shares, and so on.

Example of Buyback

Suppose R.K Ltd. has 10,00,000 outstanding shares out of which the board of directors decides to buy back 1,00,000 shares at a maximum price of ₹500 per share through open market purchases.

Impacts:

• The total outstanding shares are reduced from 10,00,000 to 9,00,000.
• The company has the option to either cancel the repurchased shares or hold them as treasury stock.
• The value of remaining shareholders increases as now they own a larger percentage of the company.
• Earnings per share (EPS) may increase as the profit is distributed among fewer shareholders.

Reasons for Buyback

The decision to implement a share buyback is backed by several strategic, financial, and market considerations. Some common reasons for buyback are,

1. Capital Structure Optimization: A company may optimize its capital structure through a buyback program. A buyback reduces the number of outstanding shares that in return increases the value of shares, Earning per Share (EPS), and Return on Equity (ROE).

2. Undervaluation of Stock: A buyback program presents a company’s opinion that its shares are undervalued in the market. As a solution to this, buyback is executed to reflect the strong financial position and current valuation of a company. A buyback adds to the market reputation and increases the market valuation of a company which increases the value of the remaining shareholders.

3. Excess Cash Reserves: A company with huge cash reserves and fewer investment opportunities may look forward to buyback. Excess cash kept in an account hurts cash flow, so the company efficiently deploys surplus funds through a stock buyback.

4. Rewarding Shareholders: A buyback is looked at as an attractive option to reward the shareholders in case of significant cash flows. A company can distribute value to investors by returning cash to its shareholders through buyback.

5. Tax-Efficient: The shareholders prefer buyback of stock instead of huge dividends as it can be tax efficient. The shareholders can claim exemptions and tax treatment under the capital gain head.

6. Restraining Power and Control: A company may also implement buyback to restrain the control of management and prevent dilution of control. This helps in quick and efficient decision-making without much conflict.

Impacts of Buyback

I. Impacts of Buyback on Company

1. Optimization of Capital Structure: By utilizing excess cash reserve for repurchasing the shares, the company optimizes its capital structure. A buyback leads to a potential enhancement of earnings per share (EPS), by reducing the total number of outstanding shares. A buyback also improves other financial ratios such as return on equity (ROE) and return on assets (ROA).

2. Restraining Power and Control: A buyback helps company to reduce the dilution caused by employee stock option programs. This promotes stability in capital structure and prevents excessive dilution of management and control.

3. Barriers to Hostile Takeovers: Share buybacks reduce the number of available shares in the market and make it more expensive. This creates a challenging situation for potential acquirers to gain a controlling interest within a company, hence protecting the company from takeovers.

4. Financial Flexibility for Future Mergers and Acquisitions: A buyback program helps the company to take advantage of strategic opportunities. A reduced number of outstanding shares increases the financial flexibility of the company and enhances the ease of future mergers and acquisitions.

5. Impact on Debt Ratios: When a company funds its share buyback through debt, it adds financial leverage to the company’s capital structure. Using debt for buybacks can be cost-effective and have a positive impact on debt-ratio.

6. Market Indicator and Share Price Movement: The announcement and execution of a buyback creates a positive image of the company in the market. It reflects a strong financial position and the company’s belief that the stock is undervalued. This boosts the confidence among investors and potentially attracts new investors which may lead to an increase in the company’s stock price.

II. Impacts of Buyback on Shareholders

1. Shareholder Value Creation: A buyback reduces the number of outstanding shares and can lead to an increase in the company’s stock price. Hence, creates value for existing shareholders. The Buyback promotes optimization of the company’s capital structure that leads to the potential enhancement of earnings per share (EPS).

2. Better Reward: Buyback offers a higher price to shareholders than the prevailing market price. It can be a better return in comparison to dividends.

3. Better Decision Making: The company executes a buyback to attain some financial and strategic goals and reports the updates to investors throughout the buyback period. This helps investors to make better decisions. However, investors should be cautious if buybacks are primarily driven by short-term financial goals.

Criticism of Buyback

Despite the potential benefits, share buybacks (stock repurchases) have faced certain criticism,

1. Short-Term Financial Objective: A buyback may be executed with some short-term financial goals like increasing earnings per share (EPS) that may benefit shareholders with short-term interest. However, focusing on short-term interest may adversely affect the long-term goals.

2. Lack of Strategic Investment: A company may prioritize share buybacks over strategic investments in innovation, technology, and workforce development which hampers the operational ability and competitive advantages of the company.

3. Opportunity Cost: A buyback has some opportunity cost. The funds used for the execution of the buyback could be used for investment and development projects, so it is always advisable to evaluate the opportunity cost of the buyback.

4. Wealth Inequality: Buyback offers handsome amounts to wealthy investors with larger stock holdings. This leads to unequal distribution of wealth which is not good for an economy.

5. Cost-effective Debt Ratio: Buybacks funded through debts provide leverage but the concern is rise in the cost of debt and increased interest rate that may burden the company’s debt ratio and capital structure.

6. Misguidance: A buyback is a tool to artificially boost earnings per share without a corresponding increase in actual earnings. This illusion of improved financial performance may misguide the investors and market executives.

How is Buyback Done?

A share buybacks can be executed using different methods depending upon the company’s goals, financial situation, and the regulatory environment. Here are some common methods,

1. Open Market Purchases: Under this, the company buys shares directly from the open market through a broker. It is executed gradually over a longer period to minimizes market impact. This method is cost-effective as shares are generally bought back at market price.

2. Tender Offers: Here the company makes a public announcement about the buyback specifying the number of shares it intends to repurchase at the specific price. The interested shareholders may tender their shares at that price. This method promotes transparency and helps the company to control the quantity of shares to be repurchased.

3. Dutch Auction: The company announces a price range within which it is willing to repurchase its shares. The interested shareholders submit offers specifing the quantity of shares and the price. Then the company determines the lowest price at which it can repurchase the desired quantity of shares and implement a buyback program.

4. Private Negotiation: In this method, the company privately negotiates with an individual or group of shareholders or institutional investors to repurchase shares at a negotiated price. It is a cost-effective method but requires a long time and attention.

What does Share Buyback Signify?

A buyback signifies the current financial situation and the company’s confidence in future earnings and cash flow. It signifies the capital allocation strategies of the company and also reflects the boost in the earnings per share. A debt-funded buyback adds on financial leverage, but it is sad to note that a boost in earnings per share and improvement in other financial ratios is short-term and the opportunity cost of a buyback can be long-term financial gains. Hence, it is important to understand the actual cause and impact of buyback before making decisions.

Difference Between Dividend and Share Buyback

Basis	Dividend	Buybacks
Meaning	The dividend is a reward paid to the shareholders out of profit.	Buyback is repurchasing the shares from shareholders at a specified price.
Frequency	Paid at regular intervals (ed. quarterly, half-yearly or annually)	Irregular in nature
Beneficiary	Existing Shareholders	Surrendering Shareholders
Impact on Cash Flow	Directly affects the cash flow and contributes to cash outflow.	Uses cash reserve anthe d impact on cash flow is spread over time.
Impact on shareholding	Does not affect the holding of shareholders	Reduces the shareholding of shareholders.
Impact on Capital Structure	Reduces retain earning and profit	Affects the capital structure and reduces the outstanding shares
Taxability	Taxable in the hand of the individual shareholders	No immediate tax implied
Investor Preferences	Attracts income-seeking investors	Attracts investors seeking potential capital gains
Market Conditions	Dividends are stable and not affected by market conditions	highly influenced by market conditions

Frequently Asked Questions (FAQs)

1. What is a share buyback?

Answer:

A buyback is a corporate action of repurchasing the shares from the shareholders at specified price from the open market or directly from its shareholders.

2. Why do companies opt for share buybacks?

Answer:

Companies may undertake share buybacks for various reasons like increasing the value of stocks, enhancing earnings per share (EPS), optimizing capital structure, indicating strong financial position, returning excess cash to shareholders, and so on.

3. How are share buybacks funded?

Answer:

A buybacks are financed through the company’s available cash reserves but in some cases, companies may use debt to add financial leverage.

4. How does a share buyback impact financial ratios?

Answer:

A buyback improves metrics like earnings per share (EPS), return on equity (ROE), and other ratios related to earnings and capital structure by reducing the number of outstanding shares.

5. Can a share buyback be reversed?

Answer:

A buybacked shares are generally cancelled by the companies to reduce the outstanding holdings. However, this decision depends upon the company’s strategies and capital structure considerations.