Buyback of Shares: Meaning and Reasons

Buyback of Shares: Meaning and Reasons

7 mins readComment
Chanchal
Chanchal Aggarwal
Senior Executive Content
Updated on Apr 9, 2024 15:53 IST

A buyback of shares is a corporate action where a company purchases its own stock from the marketplace, reducing the number of outstanding shares. This strategy can increase the value of remaining shares and improve financial ratios, signalling the company's confidence in its own future prospects.

Buyback of shares

When a corporation like Apple decides its stock is undervalued, it might initiate a share buyback, purchasing its own shares from the market. This action reduces the total shares available, aiming to boost the stock's value and signal confidence in the company's financial health, thereby directly benefiting remaining shareholders by increasing their stake's value.

Table of Content

Buyback of Shares Meaning

A share buyback, also known as a share repurchase, is a strategic move by a company to buy its own shares from the stock market or directly from its shareholders. This action decreases the total number of shares in circulation, effectively amplifying the ownership stake of the remaining shareholders. 

Companies buy back shares at a higher price than the current market price. Buyback of shares can be divided into two types: tender offer and open market offer. 

Tender Offer

A Tender Offer in a buyback of shares is a public offer made by a company to its shareholders to purchase a portion of their shares at a specified price and within a set timeframe. This allows shareholders to tender or sell their shares back to the company. 

Open-Market Offer

In an open-market offer, the company repurchases its shares directly from the stock market rather than through a formal tender offer. In this method, the company buys its shares gradually over time in the open market at the prevailing market prices. 

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Reasons for Buyback

Enhancing Shareholder Value

Share buybacks are often undertaken to enhance shareholder value by reducing the number of outstanding shares. This action can lead to an increase in share price and a higher proportion of company ownership for remaining shareholders. It makes each share more valuable and potentially increases the overall return on their investment.

Improving Financial Ratios

Buybacks can positively impact key financial metrics such as earnings per share (EPS) and return on equity (ROE). By reducing the number of shares outstanding without altering the company's earnings, buybacks can make the company appear more profitable and efficient, attracting more investors and potentially increasing the stock price.

Excess Cash Distribution

Companies with excess cash reserves may choose to buy back shares as a way to return capital to shareholders. This method is often preferred when the company views its shares as undervalued or when it seeks to distribute cash without committing to the recurring expense of dividend payments, thus optimizing shareholder value.

Signalling Confidence

A buyback can act as a signal to the market that the company's management believes its shares are undervalued. This vote of confidence from insiders can encourage investors, suggesting that the company has strong future prospects and that its current stock price does not reflect its true value, potentially leading to market revaluation.

Tax Efficiency

In certain jurisdictions, share buybacks can offer tax advantages over dividends. While dividends are typically taxed as income in the hands of shareholders, buybacks can lead to capital gains, which may be taxed at a lower rate or deferred until the sale of the shares, providing a more tax-efficient method of returning capital to shareholders.

Avoiding Takeovers

Reducing the number of shares available in the open market can make it more difficult for hostile parties to accumulate a significant stake in the company, thereby helping to protect against unwanted takeover attempts. This strategy can be particularly appealing for companies looking to maintain control and safeguard their strategic direction.

Capital Structure Optimization

Companies may engage in share buybacks as a strategy to optimize their capital structure. By adjusting the balance between equity and debt, companies can aim for a more efficient capital structure that lowers the cost of capital and maximizes shareholder value, often making the company more attractive to investors.

Employee Compensation Plans

Buybacks can be used to acquire shares needed for employee compensation plans, such as stock options or other equity-based incentives. This allows companies to reward and retain key employees without diluting existing shareholders' equity, aligning the interests of employees and shareholders towards the company's success.

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Example of Buyback of Shares

In 2020, Infosys, a major Indian IT company, announced a share buyback program worth ₹9,200 crore at ₹1,750 per share. This move aimed to return surplus cash to its shareholders, enhance earnings per share, and signal confidence in the company's intrinsic value, reflecting a strategic effort to optimize capital allocation and shareholder value in the Indian market.

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Buyback Process

The buyback process typically involves several key steps that companies follow to repurchase shares from the market or shareholders. Here's a general overview of the process:

Board Approval: The company's board of directors first approves the buyback proposal, including the maximum number of shares to be bought back, the buyback method, and the price range.

Regulatory Compliance: In many jurisdictions, the company must then file the buyback proposal with the relevant regulatory body, such as the Securities and Exchange Board of India (SEBI) in India or the Securities and Exchange Commission (SEC) in the United States, and comply with specific regulations designed to protect investors.

Public Announcement: The company publicly announces the buyback plan, detailing the terms and conditions, including the number of shares to be repurchased, the buyback price, and the time frame.

Buyback Method: The company decides on the method of buyback, which could be through the open market, a tender offer to existing shareholders, or a direct purchase from specific shareholders.

Open Market Purchases: The company buys shares at the prevailing market price up to the specified price limit.

Tender Offer: Shareholders are invited to tender their shares at a fixed price, usually at a premium to the market price.

Direct Purchase: The company negotiates directly with large shareholders to buy back shares.

Implementation: For open market purchases, the company buys back shares over a period, often through a broker. In a tender offer, shareholders submit their shares, and the company buys them back at the specified price.

Cancellation of Shares: Once repurchased, the shares are usually canceled and become treasury shares, reducing the total number of outstanding shares.

Disclosure: Throughout the buyback process, companies are required to make periodic disclosures to regulatory authorities and investors, detailing the progress of the buyback, including the number of shares bought back and the amount spent.

Completion: The buyback process concludes once the company has repurchased the desired number of shares or the buyback period has ended. A final report summarizing the buyback's outcome is often published.

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Impact of Share Buyback

Share buybacks can have several impacts, both on the company itself and on its shareholders:

Impact on the Company:

Reduces the number of outstanding shares: This increases the ownership stake of remaining shareholders and can boost the company's earnings per share (EPS).

Signals management's confidence: A buyback program signals that the company's management believes the stock is undervalued and presents an attractive investment opportunity.

Optimizes capital structure: Buybacks can help the company achieve its desired debt-to-equity ratio and improve financial ratios.

Offsets dilution: Buybacks can counteract the dilutive effect of employee stock-based compensation programs.

Impact on Shareholders:

Increased ownership stake: With fewer shares outstanding, each shareholder's proportional ownership in the company increases.

Potential stock price appreciation: A buyback's signalling effect can lead to an increase in the company's stock price, benefiting existing shareholders.

Potential dividend increase: If the company's earnings remain the same, the reduction in shares outstanding can lead to a higher dividend per share.

Tax implications: Depending on the jurisdiction, capital gains from share buybacks may be taxed differently than dividends.

Broader Market Impact:

Demand for the company's stock: Buybacks can increase the demand for the company's shares, potentially leading to a rise in the stock price and affecting the broader market.

Market liquidity: Buybacks can affect market liquidity as the company becomes a consistent buyer of its own shares.

Regulatory oversight: Share buybacks are subject to regulatory scrutiny to ensure they are not used for market manipulation or other unethical practices.

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Conclusion

Share buybacks are financial strategies companies use to return wealth to shareholders. They enhance shareholder value and signal confidence in their own future prospects. By reducing the number of outstanding shares, buybacks can improve financial ratios and potentially increase the share price. Also, it offers a tax-efficient way to distribute excess cash, aligning with long-term corporate strategies.

Top FAQs on Buyback of Shares

What is a buyback of shares?

A buyback of shares occurs when a company purchases its own shares from the stock market or directly from its shareholders, reducing the total number of shares in circulation.

Why do companies buy back shares?

Companies buy back shares to return excess cash to shareholders, improve financial ratios like EPS and ROE, signal confidence in the company's financial health, adjust the capital structure, or deter potential takeover threats.

How does a buyback affect share price?

Buybacks can lead to an increase in share price due to the reduced supply of shares in the market and the perception of confidence from the company's management in its own future prospects.

Are buybacks always a positive signal?

While buybacks can signal management's confidence, they are not always positive. They might also indicate a lack of profitable investment opportunities or be used to artificially inflate financial metrics.

About the Author
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Chanchal Aggarwal
Senior Executive Content

Chanchal is a creative and enthusiastic content creator who enjoys writing research-driven, audience-specific and engaging content. Her curiosity for learning and exploring makes her a suitable writer for a variety ... Read Full Bio