Advantages and Disadvantages of Share Buyback

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  • 18 Dec 2023
Advantages and Disadvantages of Share Buyback

Key Highlights

  • In a share buyback, the companies repurchase their outstanding shares from the shareholders.

  • Share buybacks increase promoter's control and enhance the earnings per share (EPS).

  • The key advantages of share buyback are efficient use of cash reserves, protection against a hostile takeover and provides positive growth prospects.

  • Miscalculation of company valuation and delay in major investment projects are some of the major drawbacks of a share buyback.

Share buyback refers to the practice of firms buying back their own shares from current owners, either through an open market transaction or a tender offer. The price of these shares is typically higher than the existing market price.

Companies can use the secondary market to repurchase shares if they want to use the open market process. However, those who choose the tender offer can submit a part of their shares within the allotted time. On the other hand, it might be an alternative way to reward current shareholders besides paying dividends.

A company may have several reasons to go for a buyback. Here are the prominent ones.

  1. Share buyback lowers the capital base. This usually leads to higher earnings per share (EPS).
  2. It acts as a defence mechanism when there is a threat of corporate takeovers. Buybacks increase promoters' assets and protect against hostile takeovers.
  3. By encouraging companies to lower their equity base, buybacks provide the necessary flexibility.
  4. Share buybacks result in a smaller floating stock ratio. This raises the shares' intrinsic value.
  5. Repurchases would allow businesses to expand their capital bases without raising more funds through mergers and acquisitions.

There are various methods to buy back the shares. The following are the most common ones.

Buying from the Open Market

Using this strategy, the business purchases its own shares from the market. The company's brokers handle the transaction. The firm has to buy back significant blocks of shares. Thus, this repurchase program lasts relatively longer. It is not mandatory for the business to carry out the buyback program after the announcement. Additionally, it can modify the buyback program in accordance with the requirements and circumstances of the business.

Tendering

The firm issues a tender to buy the shares from the existing owners at a fixed price. The buyback price would exceed the share's current market value. Individuals interested in the share repurchase program should indicate how many shares they want to sell. The transaction will proceed if the company's buyback obligation surpasses the required threshold. Preference is given as per the number of shares investors want to sell.

Repurchase by Direct Negotiation

In this process, the business only contacts shareholders with a sizable share. They receive payment from the firm that is higher than the existing rate. This strategy is more appropriate since the business can bargain directly with bigger shareholders.

Dutch Auction Tender Offer

The origin of the concept lies in the Dutch Tulip Market of the 17th century. In this method, a firm gives the stockholders a price range rather than a fixed price. The minimum price is usually higher than the existing price. Investors place their bids within the specified range.

Better and more efficient finance management is crucial to a company's success. To repurchase several shares, firms need amassivee amount of funds from one or more sources. The companies can arrange the required capital in the following ways.

  • Internal funding by utilising the profits

  • Keep adequate cash reserves.

  • Selling a short-term investment

  • Issuing fixed deposits to raise cash

  • Issuing loan bonds and debentures

  • Loans from commercial banks

  • Overdraft facility offered by banks

The following are some of the key advantages of share buyback.

  1. Businesses with substantial cash reserves to buy back shares can efficiently use their money.

  2. Share buybacks alter the company's capital structure. Re-issue of shares is mandatory to satisfy existing commitments. So, buybacks are occasionally used as a preventative measure against share re-issues to balance the capital structure. Shares are repurchased for retirement plans, stock options, bonuses, and other re-issue requirements.

  3. Share repurchase plans indicate that the management has positive future prospects. The management may have beneficial information that is unknown to the investors. So, it may provide cash to its shareholders, expecting cash flows to rise in the future.

  4. Repurchasing shares enables promoters to create a strong defence plan during hostile takeover offers.

  5. Share buybacks enhance the promoters' position. They may occasionally acquire all the non-promoter owners' shares. They can also buy enough shares so that the promoter's holdings exceed 90% and delist the company.

  6. A firm is limited to one buyback per year. However, it can go for several buyback plans year after year. This also makes it easier for the promoters to swiftly accomplish their goals and raise their stake and control in the businesses.

  7. Repurchasing shares and securities lowers the capital base. So, it increases earnings per share (EPS) after the repurchase and significantly raises the price-earnings (P/E) ratio.

  8. If a company has enough liquidity, section 77B of the Companies Act permits the buyback of shares and securities. Share buybacks are prohibited for companies which defaulted on deposit repayments, term loans or interests. So, it is a useful tool for monitoring businesses with low liquidity.

  9. Following the share repurchase, the firms will benefit from lower capital bases and a higher dividend yield.

Here are some of the major disadvantages of the buyback of shares.

  1. The share repurchase programme can raise the EPS and ROA (return on assets) ratios, among others. The primary reason for the ratio rise is the reduction of outstanding shares. It is not due to an increase in profitability. As a result, the share repurchase may present an inaccurate picture of a company's profitability.

  2. Despite having access to all insider information, the firm's management retains the ability to misjudge a company's worth. The entire buyback programme will be pointless if the repurchase was carried out to justify the undervaluation but the corporation miscalculated the prospects.

  3. Businesses may work on large projects. Major investment choices would stop if the available cash were distributed to the shareholders through share repurchases. As a result, the company's reputation might be at risk.

  4. Repurchasing shares might be an unethical way for a company's promoters to increase their ownership stake.

Conclusion

Share buyback is the process of repurchasing the shares by a company. A share buyback allows a company's promoters to acquire many shares. A business may repurchase shares in the open market or through a tender offer. Most people think that buyback proposals help the company's shareholders. It boosts return on capital and adds value to shareholdings. However, stockholders should be cautious while accepting the offer. You must consider your financial needs and risk tolerance and decide accordingly.

FAQs on Advantages and Disadvantages of Share Buyback

Yes, share buybacks can affect the earnings per share (EPS) of a company by reducing the quantity of outstanding shares. So, after the buyback, each share represents a higher portion of the company’s total earnings.

Share buybacks raise the shareholder value by increasing the earnings per share (EPS). This leads to a rise in stock prices.

Yes, there are rules and regulations for conducting share buybacks to ensure transparency. Companies must strictly follow the guidelines of the market regulator.

Yes, a share buyback can impact the stock price of a company. This is because share buybacks reduce the quantity of outstanding shares.

A Share buyback reduces the outstanding shares, affecting key ratios like earnings per share(EPS), book value per share (BVPS), return on assets (ROE) and return on equity (ROE).

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