What is Share Repurchase/Buyback? Its Advantages and Disadvantages
The past few years have seen discussions around the wax and wane of a shares buyback or share repurchase, questioning whether it’s a healthy move for both companies and investors. While some chidings were true, a majority of them seem like misspoken facts due to a lack of understanding about the share repurchase. Financial markets accoladed companies for using share repurchase as a strategic tool to enhance operational performance.
This article shares a deeper insight into how a share repurchase is done, its advantages and disadvantages, and more.
What is a Share Repurchase?
Share buyback or share repurchase is when a company buys shares back from existing shareholders. The share repurchase or buyback deal encompasses two mutually interested parties, i.e., a shareholder and the company. Upon buying back the shares from the shareholders, the company holds maximum ownership over its business. As a result, protecting the company from hostile takeovers or underpriced acquisitions. Share buyback or share repurchase also creates the stock options facility for its employees, giving them the benefit to buy them at a discount or fixed price.
Unlike the dividend program, the share repurchase program is easy to incorporate and execute in the market. Moreover, the share repurchase is a modus operandi to give back the capital to the shareholders. Once the share repurchase is executed between the company and the shareholder, those shares are off the market.
Methods of Share Repurchase
Companies endure various nuances at the time of share repurchase globally. The company can repurchase the shares and display them as treasury shares under the assets side of the balance sheet. The other way to execute the share purchase is to buy all the shares and truncate the outstanding shares in the market. A few other ways include the following:
- Repurchasing in the Open Market: Here, the company repurchases the shares in the open market after a period They also have every right to rescind the share repurchase program or make some modifications as per the company’s requirements. Even the company is under no compulsion to initiate the share repurchase program post declaration. In case the company kickstarts the share repurchase, the whole program takes a long time because the company deals in millions.
- Tendering: The company launches a tender to purchase the shares from the current shareholders at a defined price. The share price on repurchase would be higher than the existing market price of the share. Those who are intrigued with the share repurchase program present the number of shares they want to sell back to the company. In case, if the company’s share repurchase requirement goes beyond the required limit, then the deal will take place on a pro-rata method.
- Dutch Auction Tender: Another swift way to execute a share repurchase program is through auction tender. In the previous tender, the company repurchases the shares from the shareholders by setting up a fixed price. But here, the dutch auction tender works distinctly. Instead of establishing a certain price, the company describes the range. This concept dates back to the 17th century when people used this strategy in the Dutch Tulip Market. Investors go for bidding on the allotted range.
- Share Repurchase Through Direct Negotiation: In this method, the company advances to those shareholders who have chunks of shares with them. The company directly negotiates with the shareholders in return for premium payment for the shares. Meaning, the company offers beyond the current market value of the shares.
Reasons For A Share Repurchase
There are plenty of reasons behind the share repurchase program. Below are a few of them:
- If the company finds out their shares have a decent value in the coming days, they’ll go for a share repurchase when they are inexpensive.
- Another reason could be the dilution of the company’s shares upon the extra issue of shares to the public to bring more capital into the company.
- Sometimes, the company wants to restructure the financial ratios and enhance the capital in their business. So, through share repurchase or buying back the number of outstanding shares in the market diminishes, enhancing the EPS and ROE values of the entity.
- The company executes share repurchase for ownership consolidation.
- When the market is pessimistic, the share repurchase helps in boosting the equity value, thereby assuring the investors. This move is also played to bring in new investors for additional capital purposes.
- The company can prevent other competitors from taking hold of their ownership. In a way, the share repurchase can fend off any cheap mergers or acquisitions.
- Through share repurchase, the company can buy the undervalued shares from the shareholders at a certain price, later infuse demand in the market, and sell them at a higher price again. By doing so, the company can attain more benefits in the market.
Advantages of Share Repurchase
As the adage goes like this “every coin has two sides”, the share repurchase does have pros and cons too. If you are an investor, you should know these before investing in any company:
- Companies that are not in the big leagues go for share repurchase programs to appreciate the value of the share in the market. This helps companies to get noticed by new investors, propelling them to invest.
- Shareholders are under no obligation to participate in the share repurchase deal. There are no policies that pressurize shareholders to present their shares at the company’s request.
- Companies use the share repurchase strategy when their shares are trading in the market at a low price. This is done to create additional demand in the market, resulting in trading the shares at a higher price post the buyback.
- Share repurchase helps the company during recession or at the time of market correction. It enhances the share price value of the companies possessing gains and debt ratios lesser than the average industry rates.
- There’s a tax benefit for the shareholders upon the share repurchase. If the company has more cash in hand or bank, they either issue dividends or go for share repurchase. The tax on dividends is computed on income tax slab rates, whereas the tax on share repurchase will be entitled as capital gain tax. So, if the shareholders opt for share repurchase, they’ll be in the lower tax bracket.
Disadvantages of Share Repurchase
- Although companies possess every detail of their business operations, there are possibilities of erroneous mistakes. If the prospects are either overestimated or underestimated, the share repurchase program would be disastrous.
- The share repurchase might unethically motivate the higher authorities of the company just to augment their share in the business.
- The share repurchase program has the ascendancy to administer the price of the shares in the market.
- While a majority of them claim that share repurchase is an affirmative move, the growth in the other factors like ROE, EPS, and a few other ratios is inorganic. The reason these ratios display pragmatic results is because of the profitability outcome caused due to the share repurchase.
- Companies work on huge projects. Shelling out the available funds to the shareholders in the form of a share repurchase would halt big investment decisions. This could jeopardize the company’s reputation and the deal might be called off the table.
Financing Aspects of Repurchase
Share repurchase requires adequate funds for the company to pay to the shareholders upon redeeming the existing shares in the market. Additionally, even the company’s business and growth rely on liquidity and cash availability. Some of the ways a company can finance funds for the share repurchase are as follows:
- Internal funding by pulling out from profits or reserves, etc.
- Have enough cash balances with the company
- Raising funds from the public via bonds and debentures
- Issuing fixed deposits to generate additional cash
- Close the interim investments by selling them at minimal loss
- Going for cash credit or short term loan from the bank
- Taking an overdraft from the bank
Share repurchase is a great strategy run by companies to get their business under control. The program has its share of differences and numerous methods to deal with the process. Every share repurchase program is done distinctly. No one of the methods has any obligation or onus on the shareholders to give back their shares for a predetermined price.
However, the USP is to keep the ownership and authority in their hands instead of leaving it to freeloaders to capture the company. At the end of the day, the decision lies in the hands of the shareholders whether to proceed with the selling of shares back to the company or not. If you are looking for a tax benefit, share repurchase has got an upper hand, unlike dividends.
Frequently Asked Questions Expand All
Share repurchase is done due to a multitude of reasons. There’s no single agenda that sticks to why a company goes for it. However, the purpose is to claim back the majority of authority and power from the market and reinvest in the company again.
Share repurchase is done in several ways. Each company has a different approach to the process of redeeming the shares from the shareholders. Some of the methods of share repurchase are tendering, dutch auction tender, buying back in the open market, and direct negotiation. All the processes are explained above in detail.
Yes. Share repurchase improves various financial ratios in the company like the EPS value spikes as and when the outstanding shares in the market decrease. Even the return on equity value appreciates accordingly. Following that, you’ll also witness a plunge in the PE ratio. Other than that, the shareholders also get tax benefits, where they pay less on capital gains.
Generally, when a company buys back the shares from the market, i.e., shareholders, the price of the shares elevates. Any kind of reduction in the shares in the open market causes demand and supply. This leads to supply shock and fluctuations in the share price.