What is Stock Buyback? Benefits & Drawbacks explained with Example:

Stock Buyback its benefits and drawbacks with example explained

What is Buy Back?

A listed company can return wealth to its shareholders in a variety of ways. Although stock price appreciation and dividends are the two most popular ways for a company to share its wealth with investors, there are additional ways too.

In this article, we’ll take a look at one of those options that are stock buybacks. A stock buyback, also known as a stock repurchase, is when the company buys its own shares from the open market or the tender offer, mainly via its available cash reserves. 

For example,

TCS announced that it’ll buy back 4 crore equity shares from the open market at Rs.4,500 per share worth over 18,000 crores. Wherein the stock is currently trading at a little shy of Rs.4000 per share. This way, TCS is ready to pay Rs.500 premium.

A stock repurchase allows the company to reinvest in itself. The company will get to absorb the repurchased share and cancel them thus reducing the number of outstanding shares on the market. Because there are fewer shares on the market, each investor’s relative ownership over the company increases.

Types of Stock Buyback:

Open market 

A company can purchase its own shares from the open market at market price. However, the news of a buyback often leads the share price to skyrocket since the market interprets it as a good signal.

Tender Offer

A tender offer is sent to the company’s shareholders, requesting that they surrender, or tender, a portion or all of their shares within a certain time limit. The offer will specify the number of shares that the company is willing to repurchase as well as the price range for the shares. Investors who accept the offer will specify the number of shares they wish to present as well as the price they are willing to accept. Once the company has received all of the proposals, it will determine the best rate at which it intends to purchase the shares.

For example,

TCS has asked investors to surrender their shares and is ready to pay Rs.4,500 per share. They can also go for open market purchases but that is likely gonna shoot up the stock price way over the set limit of Rs.4,500 per share.

Reasons for Buyback:

1. To increase shareholder value, buybacks enable companies with unattractive alternative capital sources to reinvest their surplus funds. A reduction in the capital base as a result of share repurchases often results in better earnings per share (EPS).

2. It is utilized as a defense strategy in an atmosphere where corporate takeovers are a serious possibility. Buy-backs protect promoters from hostile takeovers by expanding their assets.

3. It will incentivize enterprises to minimize their equity basis, increasing their flexibility.

4. A lower floating stock ratio increases the intrinsic value of the shares.

5. It would enable corporations to repurchase stock without increasing their capital base for subsequent use in mergers and acquisitions.

6. Stock purchases are employed as a financial engineering technique.

7. It is used to quantify the effect of share repurchases on the share price.

Features of Buyback:

Paperless transaction

Utilize the tender offer obtained from the company’s RTA to apply for stock buyback from the convenience of your own home.

Effortless

Credit your bank account with the allowed stock buyback sum and transfer any unsold repurchase shares to your Demat Account.

Premium valuation

To increase participation, a corporation may price its stock repurchase above the market price. Hence, under buyback, you’ll get to sell your stocks at a premium.

Multiple modes to apply

Apply for stock buybacks online or by contacting your nearest branch or customer service. The most well know modes are either β€˜open market offer’ or β€˜the tender offer’. 

Benefits of Stock Buyback:

Stability & Support to Stock price

When the economy is in trouble, share values can fall precipitously due to a variety of issues, including lower-than-expected earnings. In this case, a corporation will initiate a repurchase program if it believes its stock is undervalued. And, the stock price shoots up!

Companies will repurchase shares and then cancels the bought-out shares. This way, the number of outstanding shares count reduces and improvement in the EPS is noted. 

When earnings per share improve, the market reacts favorably, and share prices rise following the announcement of buybacks. This frequently boils down to basic supply and demand. When there is a dearth of accessible shares, an upward demand boosts share prices.

Tax Advantages

When excess cash is used to repurchase business stock rather than increase dividend payments, owners can defer capital gains in the event that share values climb. Historically, buybacks have been taxed at the capital gains rate, whereas dividends have been taxed at the regular income rate. 

If the stock is held for more than a year, the gains are taxed at a lesser rate. Buyback is preferable to giving out dividends, because of tax advantages.

Improves per-share value

There are numerous ways for prosperous businesses to determine the profitability of their stocks. However, the most frequently used metric is earnings per share (EPS). Earnings per share are sometimes seen as the single most important factor affecting share prices. It is the percentage of profit distributed to each outstanding share of ordinary stock of a corporation.

When firms repurchase shares, they effectively reduce their balance sheets’ assets and boost their return on assets. Similarly, by lowering outstanding shares while keeping the same level of performance, earnings per share will improve. For shareholders who do not sell their shares, now possess a greater percentage of the company’s stock and are paying a higher per-share price. Those that did decide to sell did so at a price they were willing to accept.

Rewards every shareholder

Though every shareholder may not be able to participate in the Buyback offer. It does reward each and every shareholder. Because a Buyback from the company is perceived as the positive one, the fruits of its benefits shall reach each and every shareholder.

Utilize excess Cash

When corporations engage in repurchase plans, they signal to investors that they have excess cash on hand. If a business has excess cash, investors need not worry about cash flow difficulties. 

More crucially, it communicates to investors that the corporation believes cash is better spent on dividends than reinvesting in other assets. In essence, this stabilizes the stock’s price and offers investors long-term stability.

Drawbacks of Buyback:

1. This may incentivize dishonest promoters to use business funds to grow their stakes.

2. It enables the regulation of share prices.

3. It may divert an organization’s cash away from profitable investments.

How to participate in a Buyback?

Open Market

The company can opt to buy back its shares by actively buying from the sellers on the exchange platform. The company mentions the period of buyback in the buyback offer. This buyback usually lasts for months as the company has to ensure that there isn’t significant price appreciation due to its buying activity.

Here you participate in the open market buyback by surrendering your shares in the open market for the company to buy.

Tender Offer

Under the tender offer, you just need to apply for such buyback via your Demat accounts – β€œConsole” page. Click on the name of the company and approve the number of shares you wish to participate in.

You may not get the benefits for all the shares so applied, but you will get benefits on a pro-rata basis. 

Conclusion:

A buyback, alternatively referred to as a stock repurchase, occurs when a corporation sells its existing stock in order to reduce the amount of free-market stock. Corporations purchase back shares for a variety of reasons, including to increase the value of existing shares by limiting the supply or preventing other shareholders from acquiring control. 

The process of repurchasing shares entails direct negotiations with significant individual shareholders, open market possibilities, tender offers, and others. The primary advantage of repurchasing shares is their adaptability. Shareholders may desire to sell back their shares or may not, and the firm may also authorize or cancel repurchases. 

Additionally, firms benefit from tax benefits and signaling opportunities. Shareholders must evaluate the legitimacy of transactions and consider the rationale behind them in order to cast an informed vote.

Are share buybacks beneficial or detrimental? As is sometimes the case in finance, there may be no definite answer to the issue. Buybacks diminish a firm’s outstanding shares and total assets, which can have a variety of consequences for the company and its investors.

When crucial ratios such as earnings per share and price-to-earnings (P/E) are considered, a share reduction increases EPS and decreases the P/E, resulting in a more attractive price. ROA and ROE ratios improve when the denominator decreases, resulting in an increase in return.

In the public market, a buyback always results in an increase in the value of the stock, which benefits shareholders. However, investors should consider whether a business is repurchasing shares solely to shore up ratios, provide temporary comfort to an ailing stock price, or avoid excessive dilution.

For more Information, Check this Video:

Disclaimer: All the information on this website is published in good faith and for general information purpose only.

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