What are buybacks and how can you benefit from them?

We know that one of the primary duties of a company is to generate wealth for shareholders. One way of generating wealth is by running and growing the business well which leads to an increase in its stock price, thereby generating wealth for the shareholders through capital appreciation. However, there is one more way through which companies can ‘return’ wealth to shareholders, and that is through stock buybacks. In this article, we will understand what are buybacks and how one can benefit from them.

What is buyback?

A buyback or a stock repurchase is a corporate action through which a company buys back its own shares from the existing shareholders using its cash reserves. This ends up reducing the number of shares outstanding in the market, thereby increasing the ownership share of the stakeholders. These repurchased shares are then cancelled by the company.

Simply put, it is a method to distribute surplus profits to shareholders, similar to issuing dividends. However, what makes a buyback different is that investors can choose to either participate in the buyback or not. They can either let the company purchase the shares from them and earn some cash, or they can choose not to sell their shares to benefit from the increase in share price which generally comes with a buyback, due to the boost in share price coming after the reduction in the outstanding shares.

Ways of buyback

Let’s now understand the two ways in which a company can conduct buybacks, using the tender offer or through the open market.

In the first method, the shareholders receive a tender offer from the company requesting them to tender a portion or all their shares within a stipulated time frame. The tender offer states the number of shares the company wishes to repurchase and the price range its willing to accept. After receiving all the offers, the company finds a right mix to repurchase the shares. To be eligible to participate in the tender offer, one must be an existing shareholder as on the record date of the buyback offer.

In the second method, which is buyback through the open market, the company can carry out the buyback through the stock exchange.

Reasons for a buyback

Firstly, the company may believe that their stock is undervalued and that the market has discounted its share price too steeply. There can be various reasons for this, like a poor economic outlook. And leadingly, the company feels that the current stock price is not reflective of the inherent value or the intrinsic value of the stock. So, by conducting a buyback, the company reduces the number of shares outstanding in the market, which ends up boosting the share price.

Secondly, the company may justify the buyback by claiming that it cannot see any foreseeable utility of the excess cash and the best use of it at the moment would be to increase shareholder wealth by initiating a buyback.

A buyback directly impacts the company’s balance sheet, which changes multiple financial ratios due to the decrease in the shares outstanding and reduction in assets, which is cash in this case. A buyback also acts a way for the company to achieve an optimal capital structure by altering the debt-to-equity ratio.

A buyback can also act as a deterrent against hostile takeovers. Promoters of the company can increase their stake in the company through the buyback which ends up strengthening their hold over the company

Impacts of a buyback

Buybacks tend to have a direct impact over the financial ratios of the company. We previously understood that a buyback reduces the company’s assets on the balance sheet, which is cash in this case. This reduction in assets leads to an increase in the return on assets (ROA). Since after the buyback there is a reduction in the shares outstanding, the return on equity (ROE) increases. Generally, the market views higher levels of ROA and ROE as positive signs for the company’s financial trajectory.

Other than these, the buyback not only boosts the share price, but also the earnings per share (EPS) of the company, due to the earnings staying the same and the number of shares outstanding reducing. But all this increase is not attributed to the increase in company productivity.

Let’s now understand what benefits a buyback delivers both to the shareholders and the company.

Another thing which a buyback implies is the presence of extra cash, which indicates that at worst, the shareholders don’t have to worry about any cash flow problems. Moreover, it also signals to shareholders that the company finds better use of its additional cash in reimbursing its shareholders instead of deploying it elsewhere. This generally portrays an investor-friendly image of the company.

Other than these benefits, one also needs to look deeply and assess the caveats which may accompany a buyback.

One should not ignore the possibility of the buyback being an artificial attempt at boosting the share price. Since we know that companies conducting buybacks usually state that the most optimal use of the excess cash which they have is through a buyback, it is also likely that the buyback may signal to investors that the market is topping out, as the company doesn’t seemingly have any more avenues to invest this extra cash into their business. Consequently, any boost in the share price would be short term and superficial in nature. This boost can also mask the underlying financial problems and may also act as a path for top executives to reach targets and increase their compensations which are usually tied with the financial performance of the company, which is boosted on paper after a buyback.

One should thoroughly analyze the underlying reasons due to which the company is conducting a buyback and ensure that the buyback will indeed end up generating wealth for the company’s shareholders, especially in the long term.

How one can participate in a buyback through the tender offer

Before everything else, one must be eligible in participating in the buyback and for that, one should hold the company’s shares in demat form on or before the record date declared by the company in its buyback announcement.

Then, the shareholders need to submit their tender request mentioning the number of shares and the price for buyback by the last date for tendering shares, which is disclosed by the company in the announcement. The shares can also be tendered online using broker platforms.

After this, the number of shares tendered for the buyback are blocked. Once the tenders are validated, the company proportionately approves the buyback requests and the shares which do not get approved for buyback get unblocked in the shareholder’s demat account. The money for the shares which were bought back by the company then gets credited in the shareholder’s bank account.

Also Read: TCS announces Rs 18,000 crore share buyback: How can Investors benefit from the opportunity?

Conclusion

To conclude, there exist a lot of factors which need to be assessed before participating in a buyback, and if one’s research is sound enough, then buybacks can prove to be an effective way for shareholders to generate wealth.