In recent years, Indian companies have embraced share buybacks, using company funds to repurchase their own stocks from the market. This trend aims to boost share prices and shareholder value. However, everyone is questioning whether these aggressive buyback strategies truly benefit companies and the Indian economy in the long run. In this article, we are explaining the stock buybacks and their different ways, processes, pros and cons, and why companies are going for aggressive buybacks?. Let’s begin!
What Do You Mean by Stock Buybacks?
Stock buybacks are also known as share repurchases. It occurrs when companies buy back their own shares from the market. This reduces the number of shares available in the market and effectively increases the ownership percentage of remaining shareholders.
Investors often view buybacks positively, believing they signaled confidence in the company’s financial health. Companies may use buybacks to return surplus cash to shareholders or to improve financial ratios.
Different Ways of Buybacks
Open-Market Share Repurchases (OMRs): Open Market Share Repurchases allow companies to buy back shares from the market instead of through tender offers. This method enables firms to set a maximum buyback price and execute purchases over a specified period, typically up to six months. OMRs signal perceived undervaluation, manage earnings per share (EPS), and return excess cash to shareholders without committing to dividends. The SEC limits daily buybacks to 25% of the prior 4-week average volume.
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Fixed-Price Tender Offers: The fixed-price tender offer is a specific method used by companies to repurchase their own shares from shareholders. This corporate action allows a company to buy back its shares at a predetermined price, typically set above the current market price, which serves as an incentive for shareholders to sell their shares back to the company. Typically, companies use these offers to repurchase more than 15% of their shares at a premium of 15% to 20% above the market price.
Auction-Based Tender Offers: In a Dutch auction tender offer, the company sets a price range and allows shareholders to bid within that range. Shareholders can indicate the price at which they are willing to sell their shares, and the company will purchase shares starting from the lowest bid until the total dollar amount allocated for the buyback is met. This method allows the company to potentially buy back shares at varying prices, depending on the bids received.
Process of Stock Buybacks
- Board Approval: The company’s board of directors first approves a buyback plan, setting the amount of shares to repurchase and the budget.
- Announcement: The company announces its buyback plan to the public, often through a press release, signaling its intent to repurchase shares.
- Funding: The company allocates funds, either from cash reserves or through borrowing, to finance the buyback.
- Market Purchase: The company buys its shares on the open market or through a tender offer, where shareholders can sell their shares back to the company at a set price.
- Reduction of Shares: The repurchased shares are either canceled or held in the company’s treasury, reducing the total number of shares outstanding.
- Impact on Shareholders: Fewer shares in circulation typically result in an increase in earnings per share (EPS) and may boost stock price. The remaining shareholders have a larger percentage of ownership in the company.
Pros and Cons of Aggressive Buybacks
Pros of Stock Buybacks
Buybacks can boost the company’s stock price. By reducing the number of shares available in the market, the company increases its earnings per share (EPS), which reduces its P/E ratio, making the stock more attractive to investors. Buybacks can offer companies more flexibility to return excess cash to shareholders compared to dividends, as they can be suspended at any time. Additionally, buybacks can help offset dilution from employee stock options and provide tax advantages compared to dividends for investors.
Cons of Stock Buybacks
Buybacks can be criticized for favoring short-term price gains over long-term investments in the business. Companies might allocate funds for buybacks instead of investing in innovation, research, or expansion, which could weaken future growth potential. Buybacks can sometimes be used as a form of market manipulation to artificially inflate stock prices and financial metrics. Buyback can lead to excessive leverage if funded by debt.
Dividend V/S Buybacks
In general, most companies are going to give dividends to the shareholders of the company.
Before April 2020, companies paid a 15% Dividend Distribution Tax (DDT) on dividends, which were tax-free for shareholders up to ₹10 lakh annually. Post-April 2020, DDT was abolished, shifting the tax responsibility to shareholders. In contrast, buybacks remain taxed at the company with a 20% Buyback Tax (BBT), while shareholders are exempt from additional taxes on buybacks.
Buybacks can signal confidence in a company’s future, potentially boosting its stock price financial metrics and reducing the number of shares outstanding. Dividends provide immediate income and do not directly affect share count or financial ratios.
Why do companies go for aggressive buybacks of their shares?
Companies typically distribute dividends to shareholders, but not all engage in share buybacks. Instead of paying dividends, companies use buybacks to return excess cash to investors. When a company buys back its own shares aggressively, it aims to reduce the number of shares available in the market. This strategy boosts earnings per share (EPS) by decreasing the number of outstanding shares.
For example, consider XYZ Company with 1 million shares and a profit of ₹1 crore. The EPS would be ₹10 per share. If the company buys back 100,000 shares, reducing the outstanding shares to 900,000, the EPS would rise to ₹11.11 per share. This increase reflects the enhanced value per share due to the reduced share count. This will also reflect a reduction in the price-to-earnings ratio (P/E).
The reduction in the outstanding shares will also create a demand for the company shares. It usually leads to a temporary rise in the stock price. Some companies for this purpose go for buybacks, so investors are aware of that. The reduction of the share also leads to improving the financial ratios, such as return on equity and return on capital, which will attract investors.
Buybacks will recreate a more concentrated ownership structure, making it more challenging for hostile entities to acquire a significant stake. By limiting the number of shareholders, buybacks strengthen control for existing stakeholders and management, serving as a defense against takeovers and boosting investor confidence. Buybacks allow promoters to increase their ownership stake in the company, enhancing their control.
Buybacks provide a tax-efficient way to distribute cash to shareholders compared to dividends. The buyback tax will be paid by the company. It will be tax-free in the shareholder’s hands. So these are all reasons the companies go for aggressive buybacks.
Also read…
List of Buybacks of Shares in India 2024
The largest issue-size buybacks of shares made by the company are displayed below the chart.
How stock buybacks affect the market
Buyback often leads to a favorable performance in the market, as it reduces the number of shares outstanding, thereby increasing earnings per share (EPS). This creates a perception of higher value among investors, often resulting in a rise in stock price. Companies that engage in buybacks typically signal confidence in their future cash flows, which can attract more investors and bolster the stock’s market performance.
Conversely, stock buybacks can have unfavorable outcomes if the company repurchases shares at inflated prices during market peaks. This can lead to a decrease in liquidity and potential misallocation of capital, diverting funds from growth opportunities. If the market reacts negatively or if external conditions change, the anticipated boost in stock price may not materialize, leaving investors disappointed.
Conclusion
We are at the end parts of the article. The companies are going for aggressive share buybacks as a strategic tool to enhance shareholder value and optimize their capital structure. This approach not only boosts key financial metrics like earnings per share but also provides a tax-efficient method of returning excess cash to investors.
While buybacks can signal corporate confidence and potentially increase stock prices, they also raise questions about long-term growth prospects and resource allocation. Do you think share buybacks truly benefit average investors? How might a company’s decision to buy back shares instead of investing in research and development affect its long-term growth prospects?
Written by Nikhil Naik
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