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

What Is 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.

Reasons for Buyback

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.
   

6. Share buybacks help return surplus cash to shareholders when there are limited investment opportunities. This offers an efficient way for companies to distribute excess funds without raising regular dividends, rewarding investors and improving capital allocation.
   

Also read: SEBI Regulations & Guidelines on Share Buyback

Different Methods of Share Buyback

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 must buy back significant blocks of shares. Thus, this repurchase programme lasts relatively longer. It is not mandatory for the business to carry out the buyback programme after the announcement. Additionally, it can modify the buyback programme 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 programme 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.

Accelerated Share Repurchase

An Accelerated Share Repurchase (ASR) is a method where a company quickly buys back a large block of its own shares from the market, typically through an agreement with an investment bank. The bank borrows shares from institutional investors and delivers them to the company, which pays cash up front. Over a set period, the bank then buys back shares in the open market to return them to the lenders. This process allows the company to immediately reduce its share count and boost key financial metrics like earnings per share (EPS). ASRs are often used to demonstrate management’s confidence and positively influence the stock price.

Employee Stock Options Buyback

An Employee Stock Options Buyback occurs when a company repurchases stock options granted to employees before they are exercised. This is typically offered to incentivise or reward employees, especially if the current market price is lower than the exercise price, making the options less attractive. By offering a buyback, the company provides liquidity and motivation to employees, reinforcing retention and morale. It can also help manage dilution by reducing the number of potential shares that may enter the market if the options were exercised. This approach is especially useful during mergers, restructuring, or when a company wants to realign its compensation strategy.

Financing Aspects of Buyback

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

• Internal funding by utilising 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
  

Do Share Buybacks Have Any Impact on Financial Metrics?

Share buybacks can significantly impact a company's financial metrics. When a company repurchases its shares, the number of outstanding shares decreases. This reduction often leads to an increase in earnings per share (EPS) since the same profit is distributed among fewer shares, making the company appear more profitable on a per-share basis. Buybacks can also improve the return on equity (ROE) by reducing shareholder equity, as cash used for buybacks is deducted from retained earnings.

Additionally, share buybacks may affect the price-to-earnings (P/E) ratio, as an increase in EPS can make the stock appear more attractive to investors. However, buybacks do not change the company's actual operational performance, making it crucial to analyse them alongside other financial indicators.

Advantages of Share Buyback

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.
   

Disadvantages of Share Buybacks

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.

Steps Involved to Execute Share Buyback

A share buyback is a structured process governed by regulatory frameworks to ensure transparency and fairness. Here are the typical steps involved:

1. Board Approval

The first step is obtaining approval from the company’s board of directors. The board evaluates the financial position, objectives, and impact on shareholders before passing a resolution to initiate the buyback.

2. Shareholder Approval (if required)

If the buyback exceeds a specific threshold (usually 10% of paid-up capital and free reserves), shareholder approval through a special resolution at a general meeting may be necessary as per regulations.

3. Public Announcement

Once approvals are in place, the company makes a public announcement, often through stock exchanges and newspapers, disclosing essential details such as the buyback price, total number of shares to be bought back, record date, and rationale behind the buyback.

4. Filing with Regulatory Authorities

The company files the buyback offer documents with regulatory authorities like the Securities and Exchange Board of India (SEBI). This ensures compliance with all legal requirements and provides transparency to stakeholders.

5. Opening of Buyback Offer

The buyback offer period opens, during which eligible shareholders can tender their shares through specified methods, such as the open market route, tender offer route, or book-building process.

6. Acceptance and Settlement

Shares tendered by shareholders are accepted as per the terms of the buyback. The company extinguishes the repurchased shares, reducing the share capital. Payment is made to shareholders whose shares have been accepted.

7. Disclosure and Reporting

Post-buyback, the company reports the outcome to regulatory authorities and the stock exchange. Final disclosures are made to keep all stakeholders informed and to ensure legal compliance. Are There Any Regulatory Measures Governing Share Buyback? Yes, share buybacks are subject to strict regulatory guidelines to ensure fairness and transparency. In India, share buybacks are governed by the Companies Act, 2013 and the SEBI (Buy-Back of Securities) Regulations, 2018. These regulations stipulate the maximum limit for buybacks, the method of repurchase (tender offer or open market), and the cooling-off period before a company can initiate another buyback.

Additionally, companies must ensure they use free reserves or surplus cash for the buyback and meet solvency criteria after the process. Disclosure of the rationale and financial impact is mandatory to protect shareholder interests.

Conclusion

A share buyback is when a company repurchases its own shares from existing shareholders. 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.