In the last 2 years we have seen a number of companies, especially companies from the technology sector, announcing buyback of shares. Before we get into the nuances of buybacks in India let us understand how the global scenario on buybacks operate. Globally, there are two ways that a company can buy back its own shares. Firstly, it is possible to buy back the shares and hold these shares as treasury stock in the balance sheet of the company. This is used by the company for treasury operations. Secondly, you can buy back the shares and extinguish the shares, thus reducing the outstanding shares to that extent. In India, the first method is not allowed and shares can only be bought back for extinguishing.

So, why does a company buy back shares? What are the reasons for buyback of shares? One needs to understand the benefits for the shareholders and for the company in question. The key question is about the share buyback benefits for shareholders.

1. Lots of cash but few projects to invest in

This is one of the primary considerations for companies to buy back shares. Typically, Indian IT companies like Infosys, TCS, Wipro and HCL Tech were sitting on billions of dollars in cash. Now, cash in the bank has a cost and it is better returned to shareholders. A company like Reliance Industries may have billions of dollars in cash but it also has massive investments in the field of telecom. Most of the IT companies are operating on matured business models and there is not much to invest in terms of new projects. Too much cash in the books and too few investment opportunities is a key reason for buyback of shares.

2. Buybacks are a more tax-effective means of rewarding shareholders

This advantage became pronounced in India after the Union Budget 2016 when the government announced the 10% tax in the hands of shareholders if the annual dividend exceeded Rs.1 million. Now, dividends paid by companies are being virtually taxed at 3 levels. Firstly, dividends are a post tax appropriation, and then there is dividend distribution tax (DDT) of 15% when the company pays out the dividend and finally there is the 10% tax on shareholders. The 10% tax actually hit promoters and large shareholders the most. In comparison, buybacks are attractive in tax terms even after considering the 10% tax on LTCG that was imposed in the 2018 budget.

3. Theoretically buybacks tend to improve valuations of companies

When a company buys back shares, it results in a reduction of the number of shares outstanding and the capital base. To that extent, it improves the EPS and the ROE of the company. When the EPS goes up, assuming the P/E remains constant the price of the stock should also go up. However, in practice it does not normally happen. When a company buys back shares it is seen as a business with very limited future investment and growth opportunities. Hence, such companies tend to quote at lower P/E ratios since P/Es are normally driven by growth. So, while the EPS goes up the lower P/E tends to neutralize the impact on valuation.

4. Company can signal that the stock is undervalued

This is perhaps the main signals that companies like to send out by buying back shares of the company. The fact that the company has confidence to use its reserves to buy back its own shares give a hint that the company management perceives it as undervalued. This is more relevant in the case of stocks that have corrected sharply despite no apparent fundamental flaws. Under these circumstances, it could be a good idea for the company to buy back the shares and signal the bottoming of prices. While the stock may not appreciate sharply, it helps the stock find a bottom in most cases.

5. Returns cash to the shareholders of the company

In India, shareholder activism by large shareholders and institutions is still not too prominent, but it is gradually building up. For example, in the US companies like Apple were forced by influential shareholders to distribute more cash to shareholders through buybacks. In the past we have seen many companies diversifying into unrelated areas just because they were flush with funds. A better idea may be to return the cash to shareholders instead and let them decide what they want to do with the excess money. That kind of shareholder activism is only just about beginning to be seen in India.

6. It can help the promoters to consolidate their stake in the company

There are times when the promoters may be worried about their holding in a company going below a certain level. A buyback is an offer and it is up to the shareholders whether to accept or not. If promoters accept the buyback then it maintains their stake and gives cash. Alternatively, if their forfeit the buyback, they are able to increase their stake in the company. This is critical when the company is wary of other companies trying to take them over.

Why Do Companies Buy Back Their Own Stock?

The main reason companies buy back their own stock is to create value for their shareholders. In this case, value means a rising share price.

Here’s how it works: Whenever there’s demand for a company’s shares, the price of the stock rises. When a company buys its own shares, it’s helping to increase the price for its stock by boosting demand, thereby creating value for all shareholders.

One of corporate America’s highest goals is to maximize shareholder value. According to this principle, a company should always aim to generate the highest possible returns for its investors. Increasing the value of its stock and returning cash to holders—in the form of dividends and share buybacks—is how companies maximize value for shareholders.

While dividend payments are perhaps the most common way to return cash to shareholders, there are advantages to stock buybacks:

• Directly boost share prices. The main goal of any share repurchase program is to deliver a higher share price. The board may feel that the company’s shares are undervalued, making it a good time to buy them. Meanwhile, investors may perceive a buyback as an expression of confidence by the management. After all, why would a company want to buy back stock it anticipated to decline in value?
• Tax efficiency. Dividend payments are taxed as income whereas rising share values aren’t taxed at all. Any holders who sell their shares back to the company may recognize capital gains taxes, naturally, but shareholders who do not sell reap the reward of a higher share value and no additional taxes.
• More flexibility than dividends. Any company that initiates a new dividend or increases an existing dividend will need to continue making payments over the long term. That’s because they risk lower share values and unhappy investors if they reduce or eliminate the dividend going forward. Meanwhile, since share buybacks are one-offs, they are much more flexible tools for management.
• Offset dilution. Growing companies may find themselves in a race to attract talent. If they issue stock options to retain employees, the options that are exercised over time increase the company’s total number of shares outstanding—and dilute existing shareholders. Buybacks are one way to offset this effect.

How Stock Buybacks Affect a Company’s Value

Since stock buybacks remove cash from a company’s balance sheet and potentially reduce the number of shares outstanding, they can have a wide impact on the key metrics investors use to value a public company.

It’s important to understand that once a company has bought back its own shares, they are either canceled—thereby permanently reducing the number of shares outstanding—or held by the company as treasury shares. These are not counted as shares outstanding, which has implications for many important measures of a company’s financial fundamentals.

Key metrics like earnings per share (EPS) are calculated by dividing a company’s net profit by the number of shares outstanding. Reduce the number of shares outstanding and you’ve given a company a higher EPS, which may make the company appear to be performing better.

The same thing goes for the price-to-earnings ratio (P/E ratio), which helps investors understand a company’s relative valuation by comparing its stock price to its EPS.

Disadvantages of Stock Buybacks

There are many critics of stock buybacks who call them a poor way for companies to create value for their shareholders. Here are some of the downsides to stock buybacks:

• Poor use of cash. Depending on many factors, stock buybacks may privilege short-term gains in share price when other more profitable uses of the cash are available. Investing in research and development or simply stockpiling cash for a rainy day may not help share prices, but they could offer better value over the longer term.
• Debt-fueled share buybacks. In the years before the Covid-19 pandemic upset the economy, up to half of all buybacks were financed by taking out debt. Low interest rates incentivized companies to borrow money to spend on share buybacks to benefit stock prices in the short term. Many critics suggest this was an especially shortsighted strategy.
• Cash-rich companies tend to have high stock prices. Some companies launching stock buybacks have built up a warchest of cash after a period of good performance. Companies in this position also tend to have relatively high share valuations, meaning they may be producing less value for shareholders than other uses of the cash.
• Used to conceal stock-based compensation to executives. Many public companies issue compensation to managers in the form of stock, which dilutes other shareholders. Executives may use buybacks to obscure how this form of compensation impacts the company’s share count.