Share Buyback – Advantages, Disadvantages, and How Does It Work

Share buyback

The share buyback is when companies buy back their own shares from the shareholders. There are multiple logics and methods that why the companies opt for buying back. However, shareholder’s approval is required for the successful execution of the transaction. The methods and reasons for the implementation of the buyback program have been discussed in the following headings.

Methods of the shares buyback

The Company can buy back the shares with two methods that include a fixed tender offer. Dutch option tender offer, open market purchase, and direct negotiation. Let’s discuss these methods of buyback in some detail.

1) Fixed Tender offer

In this type of buyback program, the Company places tender for the inviting shareholders to submit (for sale) all or portion of their shares within a certain period. The shareholders have a choice if they want to sell the share back to the Company. However, shareholders are compensated for selling their shares by paying a price greater than market value. In other words, shareholders are paid a premium for selling the shares rather than holding them in the future. That’s a win-win situation because the companies get the shares back to achieve their purpose, and shareholders get the return in the form of a premium for which investment is made.

However, it’s an expensive mode of purchase for the Company as they have to pay the price more than the current market price of the shares. But, it helps to complete the process quickly as shareholders are expected to be motivated to sell the shares because of the premium/return.

2) Dutch option tender offer

This method of the buyback is a little different from the fixed-price buyback method. In this type of tender, the Company sets the range of prices for buying back the shares while quoting a minimum price that is more than the current market price. In the next step, the shareholders bid with the number of shares to be purchases and the price.

The bid/response from the shareholders gives an idea to the Company about the price shareholders are willing to sell the shares. So, this helps them to determine the suitable price for the successful execution of the buyback program. Further, this type of buyback is expected to be completed in a relatively short time frame.

3) Open market purchase

In open market purchase, the Company buys shares from the open market over an extended period. That’s like a standard purchase from the stock market. The Company may also outline some share repurchase programs and purchase the shares after a certain period or interval.

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This buyback method provides greater flexibility as the Company can cancel their buyback program/increase the pace or bring any other changes they desire as there is no legal repercussion. Further, the purchase from the open market is cost-effective as the Company makes a purchase on the market value, and there is no premium payable as in the case of a tender offering.

However, the problem with this buyback method is that the process takes a long time because a large quantity of the shares needs to be purchased back, and shares available for sale in the market may be limited.

4) Direct negotiation

It’s another effective method for purchasing the shares; the Company reaches and negotiates the terms with specific shareholders to buy the shares. This method can be effective as both parties can sit at the table and understand the situation. However, this can be time-consuming if parties have difficulty in reaching some point of agreement.

Advantages of shares buyback

Following are some of the advantages of the buyback of the shares.

Signaling effect

It has been observed that the stock price of the Company shares increases when stock buyback is announced. It’s due to the signaling effect of the announcement as the market perceives the Company’s management is confident about its success in the future. The Company can even fund the buyback program with its retained earnings (as buyback involves purchasing shares at a premium price).

However, it’s difficult for the market to assess if the signaling effect is genuine and management is honest in their action to buy back the shares at some specific time. Sometimes, it may be planned to artificially boost the selling price as the Company executives may have some personal interest (maybe holding the shares received under employment benefit and want to sell at higher prices after buyback).

Helps in case of undervaluation

Suppose the Company assesses that its share is under-valued in the market. In that case, they can take advantage of the situation as shareholders will be willing to sell the shares at a premium because of the undervaluation. The remaining shareholders are expected to benefit from the market’s response that boosts up the share price. However, the Company’s management must be confident that their share price is trading at an undervalued price, which may not always be the case.

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However, the companies do make repurchases at the time when their prices are at the pace of rising as there are several other benefits attached with the share buyback.

Helps to avoid excess cash

Accumulation of the significant cash balances in the balance sheet might signal that the Company does not have an opportunity to invest the money and earn a return. On the other hand, significant cash balances adversely impact the stock valuation as earning potential of the business decrease with pile-ups of the cash. So, buyback of the shares can be an excellent option when the Company cannot find the investment opportunity for which return is expected to exceed the cost of capital.

Disadvantages

Following are some of the disadvantages associated with the buyback of the shares.

Opportunity cost

The shareholders invest in the Company to earn a return in the form of dividends and capital appreciation. The repurchase of the shares depletes the Company from financing. The Company may not be able to invest in the projects even that are expected to produce a significant return. So, there is an opportunity cost that may be greater than the benefit obtained with the buyback of the securities. Hence, a buyback may be a loss for the shareholders in the long run if the decision is not taken with due consideration for the availability of the financing facility.

Loss on overvaluation

The concept of the buyback is based on the idea that the Company buybacks the undervalued stock at a premium that benefits the selling shareholders and existing shareholders with the market response. However, what if the Company makes buyback at times when the share price of the Company is overvalued, it’ll lead to a premium for the selling shareholders in already overvalued price, and other shareholders who are not willing to sell will lose value from having to take on more overvalued holdings. Further, it has been observed that companies do not consider if the security is under/overvalued at the time of buyback. So, It might not always be good news when you listen about share buyback.

Risk of high leverage

If the Company needs finance for the buyback of shares, it has two options. It can raise the finance by equity or debt. Since the Company is willing to buy back the shares, the equity financing does not make sense. Hence, the only remaining option is debt financing which can be risky when the Company is already geared. Further, decreasing equity and increasing the debt might not be a good signal for the lenders. Hence, there may even be a risk of default when the risk exceeds a certain threshold. So, the Company should double think before making any decision for the buyback with the debt financing.

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Frequently asked questions

Is buyback of shares good for the Company?

The buyback of the shares is good when the Company’s share is undervalued in the market. The buyback announcement is expected to increase the confidence of the market and lead to an increase in the value of the share.

How can Company buy back shares?

There are different methods for the Company to buy back the shares that include tender, direct negotiation, and open market purchase.

Can shareholders opt not to sell the share in buyback?

Yes, the shareholder is free to choose if they want to sell the share, hold the shares, or sell some portion of the shares.

Is it a good strategy to hold half shares and sell half shares in case of buyback?

Yes, it can be a good strategy as there will be a return on selling shares which can be good for the liquidity. On the other hand, the other portion of the remaining shares is expected to rise in price, leading to capital appreciation.

Is there a tax advantage in selling shares under a buyback scheme?

Yes, the Company can distribute excess cash in the form of dividends or buyback. If excess cash is distributed in the form of a dividend, it will be taxed at the ordinary income tax rate, which is higher. On the other hand, if excess cash is distributed as a share buyback, the return will be treated as capital gain tax, which has a lower tax rate than ordinary income tax rates.

What’s the impact of shares buyback on the stock market?

The market perceives that the Company’s management is confident about the stable financial future of the Company as they can even finance the shares buyback scheme.

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