Updated July 19, 2023
Introduction to Share Buyback
When there is a large number of shares available in the capital market or open market, the company tries to buy back (purchase) its own shares from the open market for reducing the number of shares available to other shareholders so that the external shareholders should not be able to buy those shares and take the controlling interest in the company and this purchasing of own shares by returning the money to the shareholders is called as buyback of shares.
Explanation
The buyback of the shares is done when the company repurchases its own shares from the market. These shares are those which are already sold to private and public investors. Buyback of the shares is generally done at a higher price which is more than the market price of the share. In buyback of shares, the company reduces the controlling interest of the outside private or public shareholders in the company by reducing the number of shares to them and increases the controlling interest of the promoters of the company by increasing their number of shares.
Share Buyback Process
- The company presents the offer of buyback in the form of tender offers to the shareholders of the company before undergoing any buyback.
- The tender offer includes all the information about the buyback of shares like the time frame for buyback, its price, or the premium amount that shareholders get on selling the shares in the process of the buyback.
- The shareholders of the company have the option to accept, reject, or the option the buyback. The premium amount offered by the company is a kind of reward to the shareholders to sell the shares at the required time.
- If the shareholders are ready to sell the shares, the company undergoes the repurchase program. The company can also make the repurchase program just like the dividend policy in advance at its discretion. However, this is not compulsory for the company.
Example of Share Buyback
Let’s consider the company ABC Ltd which has $1 million issued share capital in the market. Due to the high competition in the market, the company faces a reduction in its earnings per share. Due to this, the company proposes to repurchase 10% of its own shares from the market at a price higher than the market price of the shares. The market price of the share is $10 per share and the company repurchase the shares at $13 per share. Due to this, the company’s earnings per share get increased automatically from $1 to $1.3, and in turn, the price-earning ratio also gets increased. This process of repurchasing shares of its own by the company from the market is an example of a buyback of shares.
Rules of Share Buyback
The rules of share Buyback are provided and discussed below-
- The buyback of the share is to be done through a single broker a day. The company can’t enter into a purchase program by way of different brokers.
- The opening transaction should not be constituted in the purchase program.
- In a single day, the company cannot make or repurchase its shares from the market exceeding 25% of the ADTV of the company.
- The company should take into account the price that was quoted independently called a transaction price, the details of which can be found in the consolidated system. The company should assure that the purchase price should not be more than that quoted independent transaction price of the shares.
- The offer of the buyback of shares should be given in the form of tenders to the shareholders in advance before implementing the buyback of shares.
Reason for Share Buyback
There can be many different reasons for which the buyback of shares is done depending on the company. Some of the reasons are provided and discussed below –
- Companies buy back their shares from the market for improving their financial health by improving the financial ratios with the buyback the number of outstanding shares of the company will reduce along with its capital base, thereby improving the EPS and ROE of the company.
- Companies buy back their shares for taking advantage of the undervalued price of their shares in the market. With this, the company can buy its own shares at a reduced price and sell them again in the market at high prices when the market has corrected.
- Companies buyback their shares for some consolidation purposes.
- Buyback of shares is also done in order to gain more confidence of the investors by which the company can attract new investors as well. This is mainly when there is market pessimism as in that case, the buyback equity value of the company will increase along with the trust of investors.
- The process of mergers or attempting hostile takeovers can be prevented by the buyback of shares.
Advantages
- The process of buyback of shares is very flexible. There requires no policy required in the distribution of dividends. Also, shareholders of the company are under no obligation to sell their shares to the company.
- The Capital gain tax rate is lower than the dividend tax rates in many countries. Hence, for the investors, it is better to buy back the shares instead of dividends.
- The share Buyback gives the indication that the company is planning to make its shares participate in the growth phase which is undervalued in the market.
Disadvantages
- The buyback of shares does not represent the real picture of the economic market. It is shown by the companies that the various financial ratios of the company get improved due to share Buyback, however, financial ratios get improved due to the decrease in the number of outstanding shares.
- The process of the buyback is undertaken by the management of the company. Hence, there can lot of errors or mistakes done by the management in the valuation of the company along with other assumptions taken by the management.
Conclusion
Along with positive signs of the buyback process, there can be negative signs also. Some companies buy back their shares because they don’t have any other profitable strategies for the improvement of their undervalued share. Companies can buy back their shares to make the shares a part of the future growth phase, which is a positive sign. So, the investors of the company should analyze the actions and the other decisions of the company in order to have sound knowledge of the company’s actions.
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This is a guide to Share Buyback. Here we also discuss the definition and rules of share buyback along with its advantages and disadvantages. You may also have a look at the following articles to learn more –
