Stock / Share Market
by 5paisa Research Team Last Updated: 2022-09-19T18:09:41+05:30

Introduction

Share repurchasing or the buyback of shares meaning is when a company purchases back its outstanding shares to reduce the number of shares available in the open market.

There are multiple reasons why companies tend to buy back shares like increasing the value of the remaining available shares by reducing their supply or as an attempt to prevent any other shareholder from taking a controlling share. 

Repurchasing the shares available in the market reduces the number of outstanding shares. Later, the earnings per share inflate along with the stock price. A share buyback is also an attempt by the company to demonstrate to its investors that it has sufficient liquidity for emergencies.

A company can buy back its shares in two ways. 
1.  The company can repurchase its shares and hold them on the balance sheet as treasury stock. The company can use these shares for treasury operations. 
2.  They can extinguish the shares after buying back, thus greatly reducing the outstanding shares.  

In India, a company can only buy back shares to extinguish them, not to hold them as treasury operations.
 

How Does a "Buyback" Work?

A buyback is an approach that allows companies to invest in themselves. By reducing the number of outstanding shares on the market, a company increases the proportion of shares owned by its investors. This happens if the company believes its shares to be undervalued, and buying them back can help its investors with a return. 

Buying back shares while being bearish on its current operations also helps boost the proportion of allocation of earnings per share. This tactic assists in raising the price of the stock while maintaining the same price-to-earnings (P/E) ratio. As the earnings per share increases, the company’s P/ E ratio decreases, i.e., the price of the stock increases. 

Companies often reward their employees with stock rewards and stock options. They also buy back shares for compensation. To offer rewards and stock options, companies issue repurchased shares to their management and employees. This also helps to prevent diluting shares of existing shareholders.

As companies repurchase their shares by utilizing the firm’s retained earnings, the net effect of the repurchase will remain the same as when the company pays dividends to the shareholders.

Why Would Companies Execute Buybacks?

●  The repurchasing of shares allows the company to reinvest in itself. 
●  Companies buy back shares if they feel undervalued, and buyback allows them to give their investors a return.  
●  Repurchasing reduces the number of existing shares, increasing the worth of each share to a greater percentage. 
●  It enables companies to extend stock rewards and options to their management for compensation purposes.
●  Buyback of shares helps companies avoid further dilution of existing stakeholders. 
●  It is also a known way for companies to ensure no one stakeholder ends up acquiring a controlling stake in the company.
 

Some Insights on Share Buyback / Conclusion

Buyback of shares by a company can give investors the impression that the firm lacks other profitable opportunities for growth, which is a cause of concern for many growth investors searching for profit and revenue.

Share buyback can also lead to a precarious situation for the company. If the economy skydives or the company faces a financial crisis, it may not recover from the situation. Another drawback seen with the buyback of shares is artificially inflating the prices of the share in the market, which is often accompanied by higher bonuses to management executives.

Buybacks are a great opportunity for shareholders to earn a premium on their shares in the short term. However, it is crucial for shareholders to properly evaluate shares before participating in the buyback offer. Multiple factors such as offer price, use of excess money for buyback, and the company's future growth potential are crucial factors to consider when calculating the shares' valuation. 
 

Frequently Asked Questions 

Q.1: Can I sell all my shares in buyback?

Ans: An investor can participate in the buyback of shares in two ways, either through a Tender Offer or an Open Market offer. In a tender offer, the company offers to buy back its shares at a particular offer price, which the shareholders can sell their share, also referred to as tender.

To participate in the tendering process, the investor must hold the company’s shares before the record date declared by the company in its buyback announcement. The shareholder should hold the shares in Demat form.

Q.2: What are the advantages and disadvantages of the buyback of shares?

Ans: Among many advantages, the buyback of shares leads to a decrease in the number of outstanding shares in the market, leading to an inflation in the stock price. This helps investors and shareholders increase their wealth easily and affordably.

However, repurchasing shares by a company may cause an incorrect valuation of the company. This happens when companies buy back to support undervalued shares, but the company overestimates its prospects, making the entire repurchase process futile. It also boosts ratios like earnings per share. However, as the increase is not due to an increase in profitability, it cannot be perceived as organic profit growth. It may paint an unrealistic picture of the company's financial and economic reality.

Q3: How do you calculate the buyback price?

Ans: The offer price is one of the most crucial factors in the valuation of a stock buyback. For buyback to be profitable, the buyback offer price must be significantly higher than the prevailing market price of the stock. 

Another major factor to consider is if the company is using excess money for stock buyback or not. Any surplus cash on the company's balance sheet represents inefficient asset utilization. However, if there is a lack of other profitable opportunities in the future for the company, a buyback may prove to be a positive decision. 

One of the most crucial factors is the company's future growth potential. For companies with solid fundamentals and future growth prospects, shareholders should keep the shares instead of participating in the stock buyback.
 

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