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Share or stock buyback is the practice where companies decide to purchase their own share from their existing shareholders either through a tender offer or through an open market. In such a situation, the price of concerning shares is higher than the prevailing market price.
When companies decide to opt for the open market mechanism to repurchase shares, they can do so through the secondary market. On the other hand, those who choose the tender offer can avail the same by submitting or tendering a portion of their shares within a given period. Alternatively, it can be looked at as a means to reward existing shareholders other than offering timely dividends.
However, company owners may have several reasons for repurchasing their stocks. Individuals should make a point to find out the underlying causes to make the most of such decisions and also to benefit from it accordingly.
There may be several reasons why a company opts for a stock buyback. However, the list below highlights the most common reasons for the same.
- When there is excess cash but not enough projects to invest in
Companies issue shares to raise equity capital and expand its venture, but often such a practice does not prove to be of much use. Similarly, keeping excess money at the bank is more like a truncated cash flow offering liquidity over the ideal requirement. Hence, instead of piling on cash reserves, companies with robust financial standing tend to make the best possible use of the cash available through a stock buyback.
- It is a tax-effective rewarding option
When compared to dividends, share buybacks are more tax-effective for both companies and their shareholders. To elaborate, stock buybacks are subjected only to DDT, and the amount of money is deducted before distributing the earnings to the surrendering shareholders. On the other hand, dividends are taxed at 3 different levels.
- To consolidate hold over the company
Often when the number of shareholders of a company exceeds the manageable limit, it becomes challenging for the entity to reach a decision unanimously. Additionally, it may result in a power struggle within the company and among the shareholders with voting rights. To avoid or aggravate such situations, company board members often resort to share buybacks and plan to consolidate their hold over the company by increasing their voting rights.
For instance, OYO Rooms’ attempt to repurchase shares worth $1.5 billion from Lightspeed and Sequoia Capital is one the most recent examples of buyback of shares in 2020. The success of such a proposal would increase the company CEO’s current shareholding from a meager 10% to 30% and strengthen his hold over the company.
- To signal that the stock is undervalued
When a company decides to buy back its shares, it may also indicate that the company considers its shares to be undervalued. Besides serving as a remedy for the situation, it also helps to project a positive picture of the company’s prospect and its current valuation.
Other than these, stock buybacks may be prompted to improve companies’ overall valuation or to reward their existing shareholders.
The following pointers highlight the impact of a stock buyback on a company’s different financial aspects.
- Effect on earnings per share (EPS)
Repurchasing a company’s shares lays a direct impact on its EPS by increasing the ratio significantly. It mainly happens because the net income tends to remain the same, while the total number of outstanding shares reduces post repurchasing.
- Effect on financial statement
The money spent to repurchase company stocks would be recorded in the business’s earnings report and can also be found in the statement of cash flow under the head ‘financial activities’ as well as the statement of retained earnings.
Besides influencing the income statement of a company, the impact of share buybacks can be noticed in other financial statements as well.
For instance, in the Balance Sheet, the record of a company’s cash holding would reduce and in turn, would lower its total assets. Simultaneously, the amount of shareholder’s equity would also undergo reduction. Notably, such a reduction would help improve performance metrics like Return on Equity (ROE) and Return on Asset (ROA).
- Effect on the company’s portfolio
Usually, companies who have faith in their prospects indulge in the practice of repurchasing their company’s share. Such a display of confidence is received positively by potential investors and existing shareholders and helps earn their trust significantly. In turn, it helps the company to enhance its market reputation and facilitates an increase in its share value naturally. All of this directly helps improve the venture’s portfolio significantly.
- Effect on increasing shareholder value
Business owners who opt for share repurchase are more likely to enhance their EPS significantly, and that too much faster than operational improvements. Investors scouting for profitable investment options tend to acknowledge companies with steady EPS as a better income-generating avenue with enhanced growth potential.
Further, it is believed that companies who are capable enough to repurchase their shares from shareholders have a grand market presence and robust pricing power. Hence, the practice of share repurchase not only helps to project a positive image of the company in the market but also comes in handy for potential investors.
Investors often believe that the declaration for upcoming buyback of shares signifies that the company’s prospect is profitable. Further, it is believed to influence the overall stock price of the company. For instance, investors often believe that repurchasing shares from shareholders are probable indications of acquisition of big companies, the launch of new and improved product lines, etc., among others.
All in all, it can be said that share buyback signifies that the stock valuation of a company is going to increase shortly. Notably, hinting at such positive prospects further helps to draw the attention of investors who wish to make the most of such favorable circumstance.
Regardless, certain companies may resort to this practice when their stock valuation decreases. It is mainly done to prevent their capital from eroding further.
As a means to identify the actual motive behind the stock buyback, investors should factor in a few things like the current trends in stock prices and current earnings per share. Additionally, it will help them understand the implications of such a decision.
Though share buybacks and dividends are different ways of rewarding a company’s shareholders, their significance is entirely different. To understand the concept better, individuals need to become familiar with the difference between the two and their underlying purpose.
To elaborate, the pointers below highlight the differences between these two –
- Dividends are earnings that are allocated to all the existing shareholders as a company. On the other hand, existing shareholders who decide to surrender a portion of their shares would benefit from share buybacks.
- When a company decides to offer a dividend to its shareholders, the total number of shares does not undergo any change. Conversely, for share buybacks, the total number of outstanding shares undergoes a reduction.
- In terms of regularity and payout frequency, most companies prefer to reward their shareholders by offering dividends. Comparatively, the practice of stock buyback is new in India and a rare occurrence.
- Typically, companies tend to declare a reward in the form of a regular, annual, special or one-time dividend. However, when it comes to share buybacks, there is no variation or type of it.
- Similarly, both dividends and share buybacks are subject to different tax treatments. To elaborate, in the case of dividends, there is a three-way tax implication. First, it is paid out from the net profit of the company, wherein, the tax has already been paid. Next, a Dividend Distribution Tax or DDT of at least 15% has to be paid by the company declaring dividends during profit allocation. Lastly, shareholders with an accrued dividend of over Rs. 10 Lakh would be liable to pay Additional Dividend Tax at the rate of 10%.
Previously, share buybacks were treated as capital gains and hence, were subjected to capital gain tax. However, post-July 2019, investors are not required to pay such a tax on their earnings through a stock buyback.Conversely, the share buyback declaring companies are entitled to deduct 20% of the generated profits as DDT before disbursing them to the shareholders.
The table below highlights the fundamental differences between dividends and stock buybacks –
|Point of Difference||Dividend||Share Buybacks|
|Beneficiary||Existing shareholders.||Surrendering shareholders.|
|Total shares||The total number of shares does not undergo any change.||The total number of outstanding shares undergoes a significant change.|
|Frequency||Dividend payouts are frequent and quite common.||Share buybacks are not very regular and relatively a new concept in India.|
|Tax treatment||Taxed at 3 levels.||Is distributed post-DDT deduction.|
|Types||There are different types of dividends, like a regular, annual, special or one-time dividend.||Share buybacks are not classified into different types.|
News of upcoming buyback NSE, or any other stock exchange for that matter, is often not as well-received as the news of dividend declaration. The reason for the same can be accredited to the fact that share buybacks signify future earnings, while dividend payouts are more current. Additionally, a company’s future stock price tends to influence its buyback value, and the gains are mostly uncertain. Regardless, stock buybacks are considered to be a more proficient way of building one’s net worth eventually.
Hence, both existing and potential shareholders should make a point to factor in the stock buyback prospect of a company and plan their investment accordingly. However, to understand its role better, they should become familiar with how it impacts investors, existing shareholders and the company from a broader perspective.