What happens when a company does a buyback?

What Is a Stock Buyback?

A stock buyback is when a public corporation utilizes cash to acquire its own shares of stock from the open market. This is done to distribute funds to shareholders that are not needed for operations or other investments. Any and all investors who wish to sell their stock can do so in a stock buyback and they are not obligated to sell back to the company. A repurchase authorization is passed by the board of directors in order to stipulate the amount of money, number of shares, or percentage of shares to be bought back.

How Buybacks Work

Buybacks are carried out in two ways:

Shareholders may be offered a tender offer, in which they have the option to submit some or all of their shares within a set timeframe at a higher price than the current market price. This additional payment compensates investors for tendering their shares and not holding onto them. Furthermore, companies may buy back shares from the open market over a long period, or even have a pre-planned share repurchase program in place, which purchases shares at specific times or on a regular basis.

A company can finance an expanded share buyback in a variety of ways, including taking on debt, using cash reserves, or drawing from its cash flow from operations. The magnitude of the buyback is likely to influence the market impact of the move; a large, expanded buyback is likely to result in an increase in the share price.

The buyback ratio is a measure of how much a company has invested in buybacks over the past year in relation to its market capitalization at the start of the buyback period. It can be used to compare the potential impact of share repurchases across different companies and is a strong indicator of how successful a company is at returning value to its shareholders. Companies that regularly buy back shares tend to outperform the broader market over time.

6 reasons why a company could consider a share buyback

The key benefit for shareholders when a company buys back its own shares is increased value for their stock. When a company buys back its own shares, it reduces the total number of outstanding shares, and this increases the value of the remaining shares. This is because the company’s earnings are spread over a smaller pool of shares, which increases the per-share earnings and the share price. Additionally, it also shows that the company has confidence in its own stock, which can further increase investor confidence and help drive up the share price. Furthermore, when a company buys back its own shares, it can improve the company’s return on equity. This is because the company is using its profits to buy back its own shares instead of distributing them to shareholders as dividends, which is another way of increasing shareholder value.

1. Lots of cash but few projects to invest in

The accumulation of large amounts of cash and lack of investment opportunities are the main reasons why companies choose to buy back shares. Indian IT companies such as Infosys, TCS, Wipro and HCL Tech have been sitting on billions of dollars in cash, and with no other lucrative opportunities, it is more beneficial to return this money to shareholders. On the other hand, companies such as Reliance Industries, who have significant investments in sectors such as telecom, may not opt for a buyback of shares since they can use the money for other purposes.

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

The Union Budget 2016 imposed a 10% tax on shareholders if their annual dividends exceeded Rs.1 million. This effectively meant that dividends were taxed at three levels: post-tax appropriation, Dividend Distribution Tax (DDT) of 15%, and finally the 10% tax on shareholders. This was especially disadvantageous for promoters and large shareholders. In comparison, buybacks remain attractive from a tax perspective, even after the 10% tax on Long-Term Capital Gains (LTCG) introduced in the 2018 budget.

3. Theoretically buybacks tend to improve valuations of companies

The Union Budget 2016 implemented a 10% tax on shareholders whose annual dividends exceeded Rs.1 million, making dividend taxation a three-level process: post-tax appropriation, Dividend Distribution Tax (DDT) of 15%, and the 10% tax on shareholders. This adversely impacted promoters and large shareholders. However, even with the 10% tax on Long-Term Capital Gains (LTCG) introduced in the 2018 budget, buybacks remain a more attractive tax option.

4. Company can signal that the stock is undervalued

The act of a company buying back its own shares is often seen as a signal of confidence in the company, indicating that the management believes the stock to be undervalued. This is especially true if the stock has recently experienced a sharp decline in price despite no obvious underlying issues. In such cases, the buyback can help to set a floor for the stock’s value, without necessarily leading to a strong appreciation in price.

5. Returns cash to the shareholders of the company

In India, shareholder activism is gradually gaining traction, with large shareholders and institutions becoming increasingly vocal in their demands. A notable example is the US-based Apple, which was recently pressured by influential shareholders to distribute more cash to shareholders through buybacks. Additionally, many companies in India have previously been observed to diversify into unrelated areas when in possession of large sums of money. A better alternative to this may be to return the excess money to shareholders, allowing them the freedom to make decisions regarding its use. Such shareholder activism is now just beginning to emerge in India.

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

When promoters are concerned that their holdings in a company may dip below a certain level, they can choose to take advantage of a buyback offer. Through this, they are able to maintain their stake in the company and receive cash. On the other hand, if they decline the buyback, they have the opportunity to increase their stake in the company, which can be important in preventing takeover attempts from other companies.

Why Do Companies Buy Back Their Own Stock?

Companies purchase their own stock in order to create value for their shareholders and help boost their share price. This is done by increasing demand for the company’s shares, thus creating value for all shareholders. Maximizing shareholder value is a key objective of corporate America, and companies often do this by returning cash to their shareholders through dividends and share buybacks. This helps to increase the value of the company’s stock and generates higher returns for investors.

While dividend payments are perhaps the most common way to return cash to shareholders, there are advantages to stock buybacks:

The main goal of any share repurchase program is to increase the value of the company’s shares. The board may believe that the shares are undervalued and that it is a good opportunity to buy them back. Shareholders may also see a buyback as a sign of confidence from the management. In addition to boosting the share price, buybacks also offer tax advantages over dividends, as they are not taxed as income. They also provide more flexibility for management compared to long-term dividend payments. Share buybacks also help companies offset dilution caused by issuing stock options to retain employees.

How Stock Buybacks Affect a Company’s Value

The smaller the denominator in the calculation, the higher the P/E ratio. In addition to improving the company’s reported EPS and P/E ratio, stock buybacks can also encourage investors to buy the company’s stock, as the reduced supply of shares makes them more scarce and, in theory, more valuable. Overall, stock buybacks can have a significant impact on a company’s financials and stock price by reducing the number of shares outstanding, increasing the reported EPS, and raising the P/E ratio. This can encourage investors to buy the company’s stock, potentially driving up its stock price.

Disadvantages of Stock Buybacks

There are many critics of stock buybacks who call them a poor way for companies to create value for their shareholders. Here are some of the downsides to stock buybacks:

Stock buybacks can often be a poor use of cash, as other uses of the money may be more beneficial for shareholders in the long run. Furthermore, debt-fueled buybacks, which were common before the Covid-19 pandemic, are viewed by many critics as particularly shortsighted. Companies with high stock prices may be producing less value for shareholders than if they used the cash for other purposes. Additionally, stock buybacks have been used in the past to conceal stock-based compensation to executives, which dilutes the holdings of other shareholders.