Understanding Pros and Cons of Share Buyback: Companies go public for one reason in particular – To raise capital for further expansion and raise the value of promoter holdings. But have you ever witnessed a company buying back its own public shares from shareholders?
While it might seem illogical to the unaware investor, there’s a strategy behind why and when companies repurchase their own shares. This blog will give you an understanding of the buyback of shares, how it works & Pros and Cons of Share Buyback.
What Is A Share Buyback?
A share repurchase is a corporate action where a company tries to buy its own shares back from shareholders, thereby reducing the number of shares in circulation in the stock market. There are multiple reasons why a company buys back its own shares, from increasing ownership stake to making existing shares more valuable.
A buyback allows a company to reinvest in itself. While the number of shares floating in the market is lesser, in turn, the value per share, as well as earnings per share, are inflated. Another reason that companies do a buyback
1. Buy shares at a discount: In bearish markets, stock prices are often trading at a discounted value, which offers the company to buy back its own stake for a lower price, for which it will pay shareholders with a small interest as well.
2. Increase The Company’s Ownership: A logical reason for a company to regain its own shares floating in the market is – Increase its voting power. Repurchasing shares gives the company a better hold over its own stake and also, a better profit margin as they do not have to distribute either dividends or profits to shareholders.
3. Rewarding Shareholders: When companies have profiteered from years of business, they tend to give out profits to their shareholders. Besides dividends and bonus issues, buyback offers shareholders cash for their time and trust in the company. What makes a buyback different from dividends is that it is not taxed the same way.
4. Improving Valuation: If the company’s board of directors feels that the stock is trading at an undervalued price in the market, they make the decision to buy back a majority stake in the company so that the share price corrects itself. With a limited supply, the price of the share is bound to increase in the market. This is the exact opposite of what happens in the case of a stock split.
Pros of Share Buyback
Here are a few of the top Pros of Share Buyback:
1. The buyback of shares improves the valuation of the company and its share price. Usually, the company repurchases the shares if it thinks that they are undervalued in the market, and this move corrects the share price to a fairer value.
2. Share Buyback builds trust among investors, as it’s a sign that the company believes in itself to the point that they want to hold a higher stake in the company.
3. Or it could be a sign that the company itself sees a greater valuation for the shares in the near future and before that, they want a better stake in the profits to come. Fewer shares floating in the market mean a better EPS value.
Cons of Share Buyback
After looking into the advantages of Share Buyback, let us also discuss a few of the cons of share buyback:
1. When a company repurchases its shares, it means that these shares are no longer available in the market for retail investors, thereby inflating the value of the shares as supply is limited.
2. When the share price is inflated, it can also affect other key metrics such as ROE, ROCE, PE, etc. giving a false sense of growth to the investors.
3. When a valuation correction doesn’t happen upon buyback, it could swing the price of the share in either direction. This means that the share price could fall instead of rising.
How does a company buy back its own shares?
There are two ways that a company can go across and repurchase shares
1. Open Market: The open market is the secondary market where shares are traded on a daily basis on listed exchanges such as the BSE and NSE. They are bought at the market price it is trading at on the day of purchase. This is the most effective way for a company to buy back its shares.
2. Tender Request: In this way, the company sends out a tender request to its shareholders asking them to sell their shares back to the company. The tender lists out the complete details of the buyback, including the price at which it will be bought back.
In this article, we looked into what is Share buyback along with the pros and cons of share buyback. Summing up, the buyback of shares can help a company as well as its shareholders, as both of them mutually benefit from this transaction.
If you’re a shareholder, then you’ll get a notice from the company through one of the depositories (CDSL or NSDL) or directly when the company decides to opt for a buyback. If you’re new to the world of investing, then sign up for Fingrad and get a three-day free trial today. Happy Investing!
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