Share buyback, also known as share repurchase, is an action to buy back the shares from the shareholders. There are two parties involved in this transaction: 1) Company and 2) Shareholders. The company buys back the shares from interested shareholders by offering them cash. There are many methods through which this transaction can happen. Also, there are certain advantages and disadvantages of this process. We will discuss them here.
METHODS OF SHARE BUYBACK
Buying From Open Market
In this method of share buyback, the company buys its own stocks from the market. This transaction happens through company’s brokers. This repurchase program happens for an extended period of time as a large block of shares needs to be bought. The company is under no obligation to conduct the repurchase program after the announcement. The company has the option to cancel it. Also, it can make changes in the repurchase program according to company’s situations and needs. If this method is effectively implemented, it can prove to be very cost effective.
Fixed Price Tender Offer
In this method, the company makes an offer to buy a fixed no. of share at a fixed price to its shareholders. The price offered by the company is above the current market price. The shareholders have the option to sell back the share or hold the shares. Interested shareholders submit the no. of shares they are willing to sell back to the company. If total no. of shares exceeds the shares required by the company, shares are bought back on a pro-rata basis. This method can be conducted quickly but it can be costlier than buying shares back from the open market.
Dutch Auction Tender Offer
This is very similar to fixed price tender offer. Instead of specifying a fixed price, the company offers a range of prices to the shareholders. The minimum price is above the current market price. For example, a stock is currently trading at $100. The company offers to buy back 2 million shares within the range of $101 to $103. Investors will bid the no. of shares and the minimum price at which he/she wants to sell the shares. The company will start qualifying bids from $101 and move to higher prices until requirement of fixed no. of shares is fulfilled. If at $102 the requirement of 2 million shares is fulfilled, every qualified bidder is paid $102. Bids above $102 will be rejected. If total bidding at $101 and $102 exceeds the requirement of shares then shares are allotted on a pro-rata basis.
Repurchase by Direct Negotiation
In this method, the company approaches only those shareholders who have a large block of shares. They are paid a premium above the current market price. This is more logical approach as the company can directly negotiate with large shareholders.
ADVANTAGES OF SHARE BUYBACK
The share buyback is flexible in nature. The share repurchase program is conducted for an extended period of time, unlike cash dividends which need to be paid immediately. Also, the company is under no compulsion to conduct the repurchase program. It can cancel it or modify it according to their needs. The shareholders are also under no compulsion to sell back the shares. They can choose to hold the shares if they want to.
Some countries have lower capital gain tax rate compared to dividend tax rate. The share buyback will be taxed under capital gain tax category. So, investors would prefer share buyback over cash dividend in such countries.
Share Buyback as a Signal
Share buyback is generally a positive signal because company perceives shares to be undervalued and it has confidence in its growth prospects. There could also be a possibility that company does not have profitable reinvestment opportunities so they are buying back the shares. This could be a negative signal for growth investors. Investors can analyze this action and its purpose to understand where the company is heading to. The idea here is that actions speak louder than words.
DISADVANTAGES OF SHARE BUYBACK
Unrealistic Picture through Ratios
Share buyback boosts some ratios like EPS, ROA, ROE etc. This increase in ratios is not because of the increase in profitability but due to a decrease in outstanding shares. It is not an organic growth in profit. Hence, the buyback will show an optimistic picture which is away from the economic reality of the company.
Judgment Error in Valuation
Though management has better access to information of the company, there are chances that they also can make mistakes about valuing the company. If the buyback is undertaken with the purpose to support the undervaluation but company overestimated the future prospects. This mistake will make the whole process of buyback futile.1–3