One of the interesting phenomenon in financial markets or for that matter equities has been the money spinning activity. They ability to buy low and sell high remains elusive for many investors to complete this process. And, the share buyback announcement made by a particular company has emerged on top of this cycle.
Theoretically, a share buyback refers to the repurchasing of shares of stock by the company that issued them. A buyback occurs when the issuing company pays shareholders the market value per share and re-absorbs that portion of its ownership that was previously distributed among public and private investors.
It is among several ways that is used by a company to return wealth to its shareholders. Although stock price appreciation and dividends are the two most common ways, there are other ways for companies to share their wealth with investors.
Share buyback is one of the most common repurchase method used by the company under regulatory mechanism.
A stock buyback, also known as a share repurchase, occurs when a company buys back its shares from the marketplace with its accumulated cash. A stock buyback is a way for a company to re-invest in itself. The repurchased shares are absorbed by the company, and the number of outstanding shares on the market is reduced. Because there are fewer shares on the market, the relative ownership stake of each investor increases.
There are two ways that companies conduct a buyback: a tender offer or through the open market.
The company shareholders receive a tender offer that requests them to submit, or tender, a portion or all of their shares within a certain time frame. The offer will state the number of shares the company wants to repurchase and a price range for the shares. Investors who accept the offer will state how many shares they want to tender along with the price they are willing to accept. Once the company has received all of the offers, it will find the right mix to buy the shares at the lowest cost.
A company can also buy its shares on the open market at the market price. It is often the case, however, that the announcement of a buyback causes the share price to rise because the market perceives it as a positive signal.
Let us understand why do companies buyback shares?
A firm’s management is likely to say that a buyback is the best use of capital at that particular time. After all, the goal of a firm’s management is to maximize return for shareholders, and a buyback typically increases shareholder value.
There are other sound motives that drive companies to repurchase shares. For example, management may feel the market has discounted its share price too steeply.
A stock price can be pummeled by the market for many reasons such as weaker-than-expected earnings results, an accounting scandal, or just a poor overall economic climate. Thus, when a company spends millions of dollars buying up its own shares, it can be a sign that management believes that the market has gone too far in discounting the shares—a positive sign.
A company may pursue a buyback is solely to improve its financial ratios—the metrics used by investors to analyze a company’s value. This motivation is questionable. If reducing the number of shares is a strategy to make the financial ratios look better and not to create more value for shareholders, there could be a problem with management. However, if a company’s motive for initiating a buyback is sound, better financial ratios as a result could simply be a byproduct of a good corporate decision. Let’s look at how this happens.
First, share buybacks reduce the number of shares outstanding. Once a company purchases its shares, it often cancels them or keeps them as treasury shares and reduces the number of shares outstanding in the process.
Moreover, buybacks reduce assets on the balance sheet, in this case, cash. As a result, return in asset (ROA) increases because assets are reduced; return on equity (ROE) increases because there is less outstanding equity. In general, the market views higher ROA and ROE as positives.
Since the company utilises cash for share buyback, it will result into reducing the total assets and hence lead to higher ROA. A similar effect can be seen for earnings per share (EPS) and, in turn, an improvement in price-earnings (P/E) multiple.
The P/E ratio is one of the most well-known and often-used measures of value. At the risk of oversimplification, the market often thinks a lower P/E ratio is better. After the buyback, the P/E decreases due to the reduction in outstanding shares. In other words, fewer shares + same earnings = higher EPS, which leads to a better P/E.
Based on the P/E ratio as a measure of value, the company is now less expensive per rupee of earnings than it was prior to the repurchase despite the fact there was no change in earnings.
Another reason that a company may move forward with a buyback is to reduce the dilution that is often caused by generous employee stock option plans (ESOP).
In many ways, a buyback is similar to a dividend because the company is distributing money to shareholders albeit in an alternative way. Traditionally, a major advantage that buybacks had over dividends was that they were taxed at the lower capital-gains tax rate. Dividends, on the other hand, are taxed at ordinary income tax rates when received. Tax rates and their effects typically change annually; thus, investors consider the annual tax rate on capital gains versus dividends as ordinary income when looking at the benefits.
Are share buyback good or bad, will be difficult to explain or to find a definitive answer, but it helps reduce the number of shares outstanding and a company’s total assets, which can affect the company and its investors in many different ways.
In the public market, a buyback will always increase the stock’s value to the benefit of shareholders. However, investors should try to ascertain whether a company is merely using buybacks to prop up ratios, provide short-term relief to an ailing stock price, or to get out from under excessive dilution.
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