A buyback allows companies to invest in themselves. By reducing the number of shares outstanding on the market, buybacks increase the proportion of shares a company owns. Buybacks can be carried out in two ways:
1. Shareholders may be presented with a tender offer whereby they have the option to submit (or tender) a portion or all of their shares within a certain time frame and at a premium to the current market price. This premium compensates investors for tendering their shares rather than holding on to them.
2. Companies buy back shares on the open market over an extended period of time.
the repurchase of outstanding shares (repurchase) by a company in order to reduce the number of shares on the market. Companies will buy back shares either to increase the value of shares still available (reducing supply), or to eliminate any threats by shareholders who may be looking for a controlling stake.
in simple words , Buy-Back is a corporate action in which a company buys back its shares from the existing shareholders usually at a price higher than market price. When it buys back, the number of shares outstanding in the market reduces and hence the market capitalisation as per below relation:
Market capitalisation = Market value * Number of shares outstanding
From a corporate point of view what could be a better investment than investing in its own shares. But why would a company invest in itself is what many of us will ponder about. Here is the answer!!
Firstly,think a bout a company having no projects to invest into and have huge cash reserves . . In that case the company may plan to invest in itself and offer the existing shareholders an option to sell their shares to the company at an attractive price. this course of action brings in dilution in the markets as outstanding shares in the market are reduced.
Secondly, a company may also opt for buybacks with an aim of projecting better valuation of their stocks in the market . The reason is companies buy its shares at higher price than current market price which indicates that its worth in the market is more than the present value, which in turn company’s stock prices goes up post buy back.
Thirdly, some companies may also use it as a tool to change their capital structure i.e. debt-equity ratio in specific. By buying back the shares from open market, a company may increase its reliance on the debt financing rather than equity financing. Moreover interest payment on debt is tax deductible. So after tax cost of debt is quite lesser than shareholders return on equity.
Fourthly, companies also go for buyback with intent of projecting better financial ratios as indicated below:
EPS: Earnings per share = Earnings/ Shares outstanding
Since outstanding shares reduce, the company’s earnings are now divided amongst less number of shares for calculating EPS value. From investor’s point of view, higher the earnings per share, better it is as an investment option. Thus even though the earnings of a company are still the same, but EPS value post buyback is increased.
RoA and RoE
When a company buys its stock, the cash assets on its balance sheets reduces. This increases the return on the assets value. And further due to reduction in the outstanding shares in the market, the RoE value also shoots up.
According to investor’s perspective , buybacks are most of the times euphoric. The reason is : either they will end up making profit by selling them to company at an attractive price or it leads to higher stock price due to reduction in outstanding shares in the open market . But as a common investor, what one should be careful about is the fundamentals of the company going for any corporate action.