Share Buyback: Meaning, Benefits and How it Works
In recent times, you might have come across the term ‘share buyback’ more frequently. This is because more and more companies are opting for this facility due to inflation-induced operational and financial reasons.
Share buyback is the process by which companies repurchase their shares from their existing shareholders at a price usually higher than what is prevailing in the market. Let’s discuss this aspect in greater detail and see how it affects investors.
What Is a Share Buyback?
In simple words, we can say that share buyback occurs when a company buys shares back from its existing shareholders. For this deal to go through, there must be two mutually agreeable parties i.e., shareholders and the company.
After successfully doing this, the company’s promoters reclaim complete ownership of the issued shares. This helps them to shield their company from any hostile or unwanted acquisition in open markets.
Now that you are aware of the meaning of share buyback, let’s shift our focus to other aspects of this concept.
Why do Companies Go for Share Repurchase?
Here are some reasons that will make you understand why companies go for share buyback:
- Excess Cash
One of the most common reasons why companies choose to go for repurchase of shares is when they have excess cash. This exercise is mostly undertaken by companies having sound financial fundamentals as parting ways with some cash portion doesn’t affect them much.
- Tax Benefits
Companies and their shareholders can also reap various tax benefits from share buybacks. Dividends received by investors are subject to taxation at three different levels. On the other hand, share buyback is subject to only dividend distribution tax. Hence, we see that it is more tax effective than other options.
Another major benefit associated with share buyback is that promoters can consolidate their hold over respective companies. Many units of smaller shareholders make it difficult to run the company’s operations and lead to boardroom conflicts. Share buybacks serve as one of the best options to counter it.
How Do Share Buybacks Work?
In order to understand share buyback, it is necessary to get an idea of earnings per share. It refers to profits incurred on one unit of share. If the number of shares reduces, which is what happens with buybacks, earnings per share improve automatically.
Generally, companies prefer to buy back shares over paying out dividends. This is because, although this exercise serves the objective of distributing profits among shareholders, share buyback also helps to increase stock valuation.
What Are the Advantages of Share Buybacks?
Some advantages of share buyback are as follows:
- It increases brand value and awareness among existing and potential investors. This is particularly important for small companies as they lack the attractiveness possessed by established houses.
- Companies tend to undertake this exercise when stock prices are trading at constantly low values. It leads to creation of additional demand and rallies stock prices.
- This exercise comes with its share of tax benefits as well. The tax incidence of this practice is low compared to the distribution of dividends.
- Stock prices are determined based on the principle of supply and demand and a buyback exercise reduces the supply in the market leading to an increase in value of the stock, since it has become rarer in the market for purchase.
Share buyback is an effective method used by companies to increase valuation of their shares and gain some popularity among big investors. It also presents a host of facilities for investors as well. During a share buyback, companies offer higher prices than the current trading value which presents an ideal opportunity for investors to book some profits and exit.
Frequently Asked Questions
What are drawbacks of share buybacks?
This method also suffers from some drawbacks. If a company overestimates the growth of stock price, a buyback may become detrimental to them. Moreover, using cash reserves for this exercise may lead to a halt in some investment and growth-oriented projects.
How do companies finance repurchases?
Various methods used by companies to finance their repurchase include internal cash reserves, issuance of fixed deposits to create more cash, overdraft or short-term credits, etc.
What is the impact of the share buyback on financial statements of companies?
Companies need to record expenses incurred on this exercise in their business earnings report. It also needs to be reported in cash flow statements and statements on retained earnings.
Are stock splits and share buybacks the same?
No, both are distinct concepts. Stock split is an issue of additional shares to the existing stockholders. However, buyback means repurchasing shares back from investors at a higher price than the market rate.