When companies decide to purchase their stock from present shareholders, whether through a tender offer or on the open market, they are said to be engaging in a buyback of shares or stocks. In such a case, the price of the shares is greater than the going rate.
Companies may repurchase shares in the secondary market using the open market process. Conversely, individuals who choose the tender offer can take advantage of it by submitting a part of their shares within a specific time frame. It is an alternative to paying dividends on time and a strategy to reward current shareholders.
However, there could be several reasons business owners decide to buy back their shares. People should make it a point to educate themselves on the root reasons in order to maximize the benefits of such decisions and profit effectively from them. You could also take positional trading tips in India. This guide explains the fundamentals of share buyback and its pros and cons.
What Are the Reasons for Share Buyback?
There are multiple reasons why share buybacks can happen. Some of them include:
- Excess Cash, Fee Projects
Corporations release shares as a means to secure equity capital for business growth. Nonetheless, this approach frequently yields limited benefits. In a comparable vein, maintaining surplus funds within financial institutions resembles an incomplete cash flow solution, offering liquidity beyond optimally necessary. Consequently, financially strong firms opt to maximize their available funds through share repurchases rather than accumulating reserves. - Tax-effective Rewarding Option
In contrast with dividends, share repurchases offer a greater tax advantage for corporations and their investors. To delve deeper, buybacks undergo a deduction of the Dividend Distribution Tax (DDT) before disbursing profits to the shareholders who relinquish their shares. Conversely, dividends are subject to taxation across three distinct tiers. - Control Over the Business
In scenarios where a company’s shareholder count surpasses a manageable threshold, achieving unanimous decisions becomes challenging. This situation can trigger internal power struggles among the company’s stakeholders and those holding voting privileges. To alleviate such complexities, board members of companies often resort to implementing share buyback strategies. This approach is designed to consolidate their influence within the company and enhance their control over voting rights.
A notable illustration of this practice occurred in 2020 with OYO Rooms’ endeavour to repurchase shares valued at INR 1.5 billion from Lightspeed and Sequoia Capital. If this initiative were successful, it would substantially elevate the CEO’s existing ownership stake from a modest 10% to a commanding 30%, reinforcing his grip on the company’s direction and decision-making. Swing trading strategies in India will provide additional knowledge. - To Show that the Stock Is Undervalued
When a corporation opts to repurchase its shares, it could suggest that it perceives them as trading below their intrinsic value. Beyond being a potential solution for this scenario, such a decision can foster a favourable perception of the company’s future outlook and present worth.
Furthermore, aside from these reasons, share buybacks might also be instigated to enhance the company’s overall market valuation or to provide recognition to its current shareholders.
Pros of Stock Buybacks
● It enhances the appearance of earnings growth.
● Repurchasing shares at a discount to their fair value may boost shareholder value.
● It can compensate for stock-based compensation dilution.
● Alternative to paying more flexible dividends.
Cons of Stock Buybacks
● Many businesses repurchase stock to increase earnings per share, sometimes at an exorbitant price.
● Reduce the balance sheet’s available cash.
● There is now a 1% excise duty on buybacks.
● They can use funds that could have been invested in new technical advancements or other, more beneficial ways.
Conclusion
In most circumstances, it is good when businesses return capital to shareholders by buybacks or dividends. In many ways, buybacks are preferable to paying dividends, mainly if the company trades below its actual value.
Stock buybacks are either suitable for investors or bad for investors, but there isn’t a universally applicable answer like there is for most investing questions. They should each be assessed individually.