What is a Buyback of Shares? Reasons & Impact

Investing in equity or stock trading is a popular way to grow wealth through capital appreciation over the long run. While considering stock investments, investors must be aware of many aspects of investing in shares, so they are aware of the impact of company actions and other aspects of investing. Something for investors to know about is a share buyback. This is essentially a share repurchase where a corporation buys back its shares from investors, that is, from the markets.  

A share buyback may occur for different reasons, but whatever they may be, investors may be potentially affected by the action of a share buyback. Investors investing in the equity market should consider any action that their stock’s value may be impacted by. In this article, you can learn about the meaning of a share buyback, the reasons it takes place, and the types of buyback that occur. You will also be able to gauge the impact of a buyback.  

What is a Buyback? 

A stock buyback or a share buyback is a practice that corporations commonly follow when they decide to buy their company shares back from the market or from their existing stockholders. If the given company is participating in a share buyback from individual shareholders in the company, the shares are bought back via a tender offer. Individuals can offer their shares to the company for sale by tendering a part of their existing company stock within a specific timeframe. From the company’s perspective, this acts as a reward for individual shareholders besides the dividends they receive from owning the stock.  

A share buyback can occur when companies buy back their shares from the open market as well. Generally, shares are bought back via the secondary market. In the case of a share buyback, the price of the said shares is typically higher than the price prevailing in the market. Furthermore, companies may choose to take the shares buyback route due to key reasons. As an investor, it is important to know some of the possible reasons for a stock buyback as you can potentially leverage such actions or they may have some impact on your investment.  

Reasons Behind a Share Buyback

Share repurchase can occur for many reasons, the most common of which are highlighted below:  

• Excess Company Capital: When companies issue shares to be purchased, they usually do so to expand company operations or to fund certain developmental projects that the company is going to take on. However, after collecting cash by issuing company stock, a company may find itself with excess capital and not enough ongoing projects to allocate the capital or invest in. With excess liquidity at the disposal of the company, the company may decide on a buyback of shares option. Note that these companies may already be financially sound firms that wish to make positive use of their capital instead of piling on cash reserves.  

• Tax-Effective Choice: The method of share repurchase adopted by companies is a more tax-effective choice than delivering dividends to shareholders. Share buybacks are more tax-efficient for investors/shareholders as well. To explain further, stock buybacks open to only DDT, and the sum of capital is deducted in advance of the earnings being distributed to shareholders surrendering their stock. In contrast, dividends are liable for tax at three distinct levels.  

• Domination of the Company: Once you know what share buyback means, you can get a handle on why companies offer to buy back their shares. One reason for companies to engage in this is so that the company can consolidate its control over the business. Typically, when the amount of shareholders exceeds a limit that is manageable by the company, it finds it difficult for the company to reach concrete decisions about its operations and general business affairs.  

Furthermore, this may lead to a power struggle between the management of the company and the shareholders who have the right to vote. To prevent this unproductive situation, board members of the company turn to solutions like a stock repurchase to consolidate their position and re-establish their voting rights.  

• Signalling an Undervalued Stock: Buying back company stock by the company that has issued them may be an indication of the company considering that its a Undervalued Stock. Hence, the buyback serves as a solution. Furthermore, it also aids in the projection of a positive trend in the prospects of the company and its present valuation.  

Besides the reasons cited above, a share repurchase may be the outcome of an objective to boost the company’s valuation overall as well as to provide rewards to shareholders already holding the company’s stock.  

Impact of a Share Buyback on the Market and Shareholders 

Surely when a company goes ahead and buys its shares back, there must be some effect on shareholders and the market. The possible impact of a share buyback takes different forms, as explained below:  

• Impact on EPS 

When a company engages in a share buyback, there is a direct effect on its EPS or earnings per share. The immediate result is that the EPS ratio increases significantly. This primarily happens because, while the net income does not change, the total amount of shares outstanding decreases after the stock repurchase.  

• Impact on the Financial Statement 

Companies that buy back stock record the amounts spent in this exercise and keep transparent accounting records of all transactions. A company’s earnings report typically shows all this data and information in detail and you can find it in the financial statement under cash flow under the sub-heading of financial activities. The information is also available in the company’s statement of retained earnings.  

Besides affecting a company’s income statement, a share buyback may be reflected in other financial statements that the company releases. For example, if you look at the company’s balance sheet, you would notice that there would be a reduction of cash holding of a company due to the buyback. Consequently, this would result in the total assets reducing. At the same time, the quantity of the equity of shareholders would drop too. In particular, this decrease would aid in improving performance metrics like ROA (return on assets) and ROE - Return on equity.  

• Impact on the Company Portfolio 

Typically, solid companies that have a sense of high self-worth and prospects tend to indulge in a share repurchase. This is a portrayal of a company’s confidence in itself and is received well by investors and shareholders. Moreover, it instills trust in potential investors and aids the company in boosting its reputation in the industry. Naturally, the potential outcome of this is that its share value rises. All this enhances the company’s portfolio substantially.   

• Impact on the Rising Shareholder Value 

Companies that choose the path of a share buyback will likely push their EPS in a positive direction and quite substantially. This is a better indicator of the company’s performance than the company’s portrayal of operational efficiency. Investors searching for potentially lucrative companies to invest in will likely consider a stable EPS metric to signal positive income generation and enhanced growth potential.  

Furthermore, investors often take the view that companies that have the ability to repurchase stock have a prominent industry presence and solid fundamentals. Consequently, the projection of such a company in the financial markets is positive from the company’s perspective and the investor’s opinion.  

Conclusion 

Companies buy back their stock from the main public markets, but a buyback of shares can take place in other ways too. The company can buy back its shares from existing shareholders of the company and this is done through a tender. Additionally, companies may buy back their shares from the open market through one of two processes: stock exchanges, or a book-building process. Companies also have the option of buying back shares from odd lot holders of the shares. However, investors must be aware of certain implications of a share buyback taking place.  

A share buyback may be viewed as a way for corporations to reward their investors as the share price of the stock bought back is at a higher rate than the market price. The process can be a fruitful way for investors to sell their shares back to the company and earn returns. Nonetheless, for long-term investors, this may not be so lucrative as certain stocks tend to rise in value over long periods, more than they would have sold back to the company during the time of a share buyback. Given this, investors must gauge their financial situations, investment goals, and investment horizon before any investment decisions are taken.