In share buybacks, the company repurchases the shares that it has issued to private and public investors in the past. The company buys back the stock by paying the current market value of the shares plus a premium as compensation to the shareholder for selling the shares when the company needs them. Recently, the trend toward share buybacks to spread returns among shareholders has increased. Let's discuss in detail why a company buys back its own stock.
Detailed concept
The Company is expected to repurchase its own shares in the following circumstances. In other words, the following motives of the company may decide to buy back the shares.
Undervalued share price
When management believes their company's stock is undervalued in the market and needs investor confidence in the security to revive its price, a share buyback can be an excellent opportunity. The question now is how buying back shares increases the market's confidence in a particular security.
The increase in confidence can be linked to the signaling effects of the buyback process. The market perceives that the company's management is confident in the company's operational and strategic performance and is preparing for a strong financial future. They even generated excess cash from operations to fund the stock buyback program. Therefore, the market is expected to be optimistic about the future development of the company, which will lead to an increase in the share price. In other words. This is due to the perception that there is less chance of economic failure and the company is expected to enjoy a prosperous financial future.
Improvement in EPS and P/E
Earnings per share and the price/earnings ratio are well known to stock market investors. Most investors compare the earnings per share and P/E of different companies before entering into call options. Investors are drawn to high earnings per share and low P/E ratios, as high earnings per share indicate that the company has generated higher earnings, which represents returns to shareholders. Likewise, a low P/E ratio indicates that the company's earnings are higher relative to the stock price.
The repurchase reduces an outstanding number of shares, which means the company's profits are spread across fewer shares. Therefore, there is an increase in EPS - which investors are attracted to when making a purchase decision. Likewise, the repurchase will result in an increase in retained earnings per share for existing shareholders.
Additionally, an increase in EPS leads to a decrease in the price-to-earnings ratio, which helps create a perception among investors that the price of the shares is low relative to the earnings of the shares. Therefore, it helps them to choose the company's higher EPS and lower P/E stocks.
Improving Return on Investments - (ROA) and Return on Equity - (ROE)
Buying back shares reduces assets and equity. As the company has to pay cash which is credited from the financial statements and debited to corresponding retained earnings, this results in a decrease in both denominators and an increase in ROA and ROE as shown in the calculation below.
In addition, share buybacks reduce the supply of shares in the market, and a reduction in supply is expected to increase the share price, which in turn brings financial benefits to shareholders.
Control over thinning EPS
The company's EPS is diluted when the company issues shares. The shares may be issued as part of a public offering, the conversion of the convertible options into equity instruments, or the issuance of the shares as part of an employment program. Issuing shares affects earnings per share because earnings are split across a larger number of shares. Therefore, EPS is diluted. At the same time, the counteraction takes place through the buyback of shares. That means EPS goes up when the number of shares goes down. Therefore, a buyback strategy can be used to control EPS.
However, the decrease in the number of shares and the improvement in EPS does not mean that the company has improved its performance; it is a change due to formula math.
Administration of voting rights / controls
Shareholders have the power to make decisions at general meetings. When there are multiple shareholders in the company, decision-making power is diluted and there may be difficulties in the smooth running of the company due to disagreements. As such, companies sometimes want power to be concentrated in certain shareholders/groups. Therefore, the company can proceed with another group of shareholders to buy back the shares and control dilution. So buying back the shares helps the company manage the concentration of power/voting rights.
remuneration purpose
Companies also buy the shares for compensation purposes. Some companies tie employee performance to stock rewards. This motivates employees to work hard. So the share price of the stock can go up. In other words, it is a practice to balance the goal of the employees with the goal of the investor. So if employees meet the targets set, the company must buy back its own stock to meet the obligation.
Best Investment
Sometimes the company may have excess cash in the bank accounts but no viable investment opportunities. No viable investment opportunity means the company cannot find the projects that are expected to generate higher returns relative to the cost of capital. So there is potential for loss if the company proceeds with such an investment. So the best investment seems to be returning the excess cash to shareholders, which can be done via a buyback.
Excess cash is a costly item on the balance sheet.
Excess cash on the balance sheet can give management peace of mind. However, there are certain costs of holding extra cash for an extended period of time. For example, the company's shareholders might be getting signals that the company is not even able to find viable investment opportunities around the world. So you might consider selling your amount and reinvesting it elsewhere.
Likewise, there is an opportunity cost to accumulating the extra money. For example, the company might manage to invest and earn a 20% return, but the company missed that opportunity by accumulating extra cash.
To avoid adverse effects of excess cash, share buyback can be an excellent practice as it creates a win-win situation for the shareholders and the company.
tax benefits
The company can distribute the return in the form of dividends or by repurchasing the shares from shareholders in return for payment of a premium price. If the company pays the return in the form of a dividend, it will be taxed at a normal income tax rate, which is higher. On the other hand, if the company pays a return through share buybacks, it will be treated as a gain on disposal and will be taxed under capital gains tax rules, which have a lower tax rate.
frequently asked Questions
Q1- In what scenarios is share buyback not a good option?
Buying back shares is not a good option when the company's share price is overvalued in the market. This will result in a loss for shareholders who choose to hold the stocks as they depreciate by holding even more overvalued stocks following market reactions.
Q2- How does the share buyback help control EPS dilution?
The share buyback reduces the number of outstanding shares. Therefore, profits are split across a smaller number of shares for a period of time. This results in improved EPS.
Q3- Is it good for the company to buy back shares to increase earnings per share?
The increase in EPS from the share buyback is not indicative of the company's improved performance as the company did not generate any additional income; it is only due to a reduction in the number of shares. However, the buyback will result in a reduction in cash and equity. Thus, the maintenance of earnings levels after the buyback may indicate the company's improved performance, unless the buyback is made with the excess cash.
Q4- What is the impact of buyback on ROA and ROE?
ROA and ROE increase with share buyback while earnings stay the same. This is because the buyback results in a reduction in assets and equity. When the same return is divided with the denominator reduced, the value of ROA and ROE increases.
We can expect the company's profitability to remain the same as the buyback is expected to be made using excess cash not used in the business.
FAQs
What are all the reasons a company would buy back its own stock? ›
Share buybacks enable companies to generate additional shareholder value. Under regular market conditions, the portion of profits that a company uses to buy back shares has a positive effect on the share price. For instance, a listed company has 1,000 shares of which a shareholder owns 100 (a 10% stake).
What do you think are the reasons that companies propose to buyback their shares from the shareholders? ›- Lots of cash but few projects to invest in. ...
- Buybacks are a more tax-effective means of rewarding shareholders. ...
- Theoretically buybacks tend to improve valuations of companies. ...
- Company can signal that the stock is undervalued. ...
- Returns cash to the shareholders of the company.
Share buybacks are a more efficient way to return capital to shareholders because the shareholder doesn't incur any additional tax on the buyback. Taxes are only triggered once the shareholder sells the shares.
What happens if a company buys back all of its stock? ›In either case, when a company buys back shares, it simply absorbs those shares into its business, and they cease to trade on the open market. For example, if a company has 1 million shares of stock outstanding and it buys back 10,000, it will then have 990,000 outstanding shares of stock.
What are the advantages and disadvantages of buyback of shares? ›Companies benefit from a stock buyback because it can preserve stock prices, consolidate ownership, and take the place of dividends. Investors can benefit because they receive their capital back; however, a repurchase doesn't always benefit investors.
Why might a company repurchase its own stock quizlet? ›Why might a company repurchase its own stock? Rationale: Companies may repurchase shares to keep the outstanding shares constant in order to reduce the dilutive effect on earnings per share that may occur when employees exercise stock options.
What are the three major reasons that a company would engage in stock repurchases? ›A company repurchases its shares when it wants to consolidate ownership, preserve stock prices, return stock prices to real value, boost financial ratios, or reduce the cost of capital.
What conditions are required to be fulfilled before a company can go for buyback? ›- The buy-back must be permitted by Articles of Association of the corporate.
- A special resolution has been passed enabling the corporate authorizing buy-back. ...
- The buy-back is 25% or less of the combination of paid-up capital and free reserves of the corporate.