In the last few years, we have seen a number of companies announcing a buyback of shares. But the question that arises is why does a company feel the need to go for a buyback? And how does buyback happen? We have answered all your queries in this article. But before we get into the nuances of buyback, let us understand what it is.
What is buyback?
A company may plan to buy some proportion of its shares from the existing shareholders when they have extra cash and can’t find an ideal investment avenue. This process of buying back its own shares is known as buyback. It is a corporate action wherein a company announces buyback to acquire shares at a price higher than the current market price from the existing shareholders in a given timeframe.
There are several reasons due to which a company may announce its buyback. A few of them are mentioned below:
- Availability of surplus cash but fewer investment avenues
- Considered as a more tax-effective option
- Improves the ROE (Return on Equity) and EPS (Earnings Per Share) as the number of shares are reduced
- Signals that a stock is undervalued
Types of buyback of shares
Below-mentioned are the most common methods through which a company can buy back shares in India.
1. Tender Offer
Under this route, the company buys back its shares from the existing shareholders on a proportionate basis within a stipulated time period.
2. Open Market (Stock Exchange Mechanism)
In the Open Market Offer, the company buys back its shares directly from the market. This buyback process consists of buying back a large number of shares and is executed via the company’s brokers over a period of time.
To know more about the effect of buybacks, read here.
Reasons for a Stock Buyback
After we have discussed what is buyback, let’s look at the reasons that can prompt a company to buy back its stocks from the market. Usually, a company repurchases shares to generate additional value for shareholders. Share buyback creates opportunities for shareholders who want to exit the investment to liquidate their investments and receive cash in return.
A stock buyback is when the company repurchases its shares to reshape its shareholding pattern. Buybacks create more value for the existing shareholders while providing additional benefits like the ones listed below.
Signalling the stocks are undervalued: The company’s management may opt for stock repurchase if they believe the shares are undervalued, and buying them back would create additional value for the remaining stocks.
Generate more returns for existing shareholders: By restructuring the shareholding patterns, the company aims to generate more value for existing shareholders. With everything else remaining constant, stock buybacks increase earnings per share.
Leverage tax efficiency: Stock buyback is more effective in reducing the tax burden on the company and investors. Dividend payments attract taxes for the investor, which can be avoided in the case of a share buyback.
Increase potential upside: With a buyback, the company tries to increase the potential upside of the stocks for existing shareholders. When fewer stocks are available for trading, it increases the value of each stock.
Prevent a hostile takeover: The company may use stock buybacks as a strategy against the possibility of a hostile takeover. It reduces the availability of stocks for a possible acquirer to obtain and gain a controlling interest in the target company.
4 Types of Buybacks
There are 4 types of share buyback practices: open market operations, a fixed price tender offer, a Dutch auction tender offer, and direct negotiation with shareholders.
Open-market offer: In an open-market offer, the company buys back its shares on the exchange, usually through brokers. The open market option offers several advantages, including allowing companies to buy stocks at a current market price, which doesn’t require them to pay a premium.
The company uses its cash reserves to repurchase its shares. The company can conduct the buyback over a period of time (it can last for months). Unlike the other buyback methods, it doesn’t impose any legal obligation on the company to conclude the buyback program within a stipulated time frame. The company usually enjoys the flexibility of cancelling the process at any time.
On the flip side, however, it can result in a possible misallocation of capital and reduce investments in growth opportunities.
Fixed-price tender offer: In a fixed-price tender process, the company announces a tender to buy back shares on a fixed date at a fixed price. The price stated in the tender is almost always higher than the price offered in the market. The shareholders have the flexibility of either accepting or declining the offer, depending on the price.
The tender remains active only for a short period, and the company needs to complete the buyback action within the stipulated window. The offer price remains fixed during the offer period.
Simplicity and transparency are the two primary advantages of this method. The price is predetermined and communicated to all shareholders so they can make an informed decision. It allows the company to acquire shares from willing shareholders.
Dutch auction tender offer: The Dutch auction is a unique method where the company willing to repurchase shares issues a tender with a range of feasible rates and a minimum price point, usually above the current market price. Shareholders consequently bid on specific quantities of shares and the minimum price at which they are willing to sell them.
The company analyses the bids to generate a demand curve to determine a suitable price within the price range specified previously in the tender to complete the buyback process. The tender offer allows for price discovery and ensures that the acquiring company pays the lowest price that satisfies its acquisition goals.
Direct negotiation: In the direct negotiation method, the company approaches several large shareholders and negotiates to buy back company shares. Unlike the other buyback methods, direct negotiation involves one-on-one discussion, and the company can target specific shareholders.
The price offered to the shareholders includes a premium but is still cost-effective. Another crucial advantage of direct negotiation is that it gives the company flexibility regarding negotiating favourable terms of the deal. However, on the downside, it is usually more time-consuming and requires more resources to identify and engage shareholders.
Tender offer vs open market offer
From the above-mentioned methods, tender offer, and open market offer (stock exchange mechanism) are the most popular buyback methods in India. Read on to know the characteristics of both the buyback mechanisms.
*In Open Market Offer, the company has an option to close the buyback when it achieves the maximum buyback size or uses at least 50% of the amount set aside for buyback, whichever is earlier.
Conclusion
The process of buying back its own shares either from the shareholders directly or through the market is known as buyback. A company can enjoy multiple benefits if it opts for a buyback such as an increase in share price, improves key financial ratios of the company, optimum utilization of the surplus cash, and more.
However, as an investor, you must not get lured by the premium offer price by the company. As a responsible investor, you must consider other aspects before applying for a buyback like why the company has announced it, its growth prospects, and what are your goals and risk appetite. Once you have made your decision to apply for a buyback, click here to know how you can apply for a buyback of shares.
FAQs
What is a share buyback?
Buyback of shares, or share repurchase, is a corporate action where a company uses its cash reserve to buy back its shares from existing shareholders.
Why do companies engage in share buybacks?
Companies may engage in the act of share buybacks for reasons including returning value to shareholders, increasing earnings per share, managing excess cash, adjusting their capital structure, defending against hostile takeovers, or signalling confidence in the company’s prospects.
How does a share buyback affect shareholders?
Share buybacks affect shareholders by reducing the number of outstanding shares, potentially increasing the value of the remaining shares, increasing earnings per share, and enhancing the percentage of their shareholding.
Are share buybacks always beneficial?
Buybacks can create value, but the extent of the impact depends on various factors, like the buyback price of shares, the company’s financial position, market conditions, the company’s long-term growth prospects, etc.
