Advantages and Disadvantages of Share Buyback

Share buybacks are a common method companies use to return capital to shareholders, manage excess cash, or influence shareholder value. This strategy can increase earnings per share (EPS). However, it may also result in higher debt levels and a focus on short-term stock price performance rather than long-term growth.

As an investor, it is important to understand the advantages and disadvantages of share buybacks. This knowledge can help you make more informed investment decisions.

Share buyback or stock repurchase, refers to a company’s decision to repurchase its shares from the stock market. This reduces the number of outstanding shares, which can lead to an increase in EPS and stock price. Companies usually buy back shares when they have excess cash or believe their stock is undervalued.

Companies typically use one of the following methods:

• Tender Offer Buyback: The company buys shares at a set price above market value, accepting shares by ratio and returning unaccepted ones

• Open Market Buyback: The company purchases shares on the open market at current prices during a set period

• Dutch Auction Buyback: Shareholders bid within a price range, and the company buys shares at the highest price where demand meets the buyback quantity

• Negotiated Buyback: The company directly agrees on terms with select investors, usually large shareholders, to repurchase shares privately

For example:

Consider a company with 1 million outstanding shares trading at ₹100 each. If it repurchases 1,00,000 shares, the outstanding shares are reduced to 9,00,000. This reduction can improve earnings per share, influence market perception, and enhance shareholder value.

Reasons for Share Buyback

Companies typically engage in buybacks for the following reasons:

• To return surplus cash to shareholders

• To increase earnings per share

• To signal confidence in future prospects

• To gain tax and capital loss benefits

• To consolidate ownership and increase control

• Tender Offer

The company offers to buy back shares directly from shareholders at a fixed price, usually at a premium.

• Open Market Purchase

 Shares are bought back from the open market over time at the prevailing market price.

• Book-Building Process

Shareholders bid within a price range, and the company buys back at the discovered price.

• Odd-Lot Buyback

Targets small shareholders holding odd lots (non-standard quantities) to reduce administrative costs.

• Buyback through Stock Exchange

The company places buy orders through the exchange, allowing shareholders to sell their shares anonymously.

Share buybacks can have several positive outcomes for both companies and investors. Below are the main advantages:

• Improved Earnings Per Share

By reducing the number of shares outstanding, share buybacks increase a company’s EPS. This key financial metric can be used to assess profitability. When the company repurchases shares, the same level of earnings is divided among fewer shares, boosting EPS.

• Potential for Share Price Increase

Share buybacks can lead to a rise in the share price. Since buybacks reduce the number of shares available in the market, they increase demand for the remaining shares. This can push the share price up, potentially resulting in capital gains for shareholders.

• Return of Excess Cash to Shareholders

If a company has excess cash and no immediate investment opportunities, it may choose to buy back shares instead of letting the cash sit idle. This method returns value to shareholders without committing to long-term dividend payments.

• Signalling Confidence in the Company’s Future

When a company buys back its shares, it signals to the market that it believes the stock is undervalued and has confidence in its future performance. This can encourage further investment in the company.

• Improved Capital Structure

Buybacks can improve a company’s capital structure by reducing the number of shares outstanding. This can enhance key financial ratios such as Return on Equity (ROE) by reducing the equity base and boosting EPS , making the company more attractive to investors.

Share buybacks offer several advantages but also carry risks and disadvantages. Below are the main drawbacks companies and shareholders should consider.

• Short-Term Focus

Share buybacks can sometimes be used to temporarily boost stock prices rather than investing in long-term growth. This short-term focus can be detrimental to a company’s financial health. It may also lead to missed opportunities for innovation, research, or new projects.

• Debt Financing

Some companies borrow money to finance buyback programs. This increases their debt load and can strain their financial health. Higher debt levels may make it harder to manage during economic downturns due to debt servicing obligations.

• Artificially Inflated EPS

Buybacks can increase EPS without improving actual earnings. EPS may rise simply because the number of shares is reduced, which can mislead investors about the company’s true performance. 

• Missed Growth Opportunities

Funds used for buybacks could have been invested in growth opportunities. For instance, the company might invest in product development, acquisitions, or infrastructure improvements. Choosing buybacks may lead to missing long-term investments that drive sustainable growth.

• Overvaluation Risk

If a company repurchases shares when they are overvalued, it risks wasting capital. Buying shares at high prices can lead to losses if the stock price subsequently falls, thereby reducing shareholder value.

Share buybacks are regulated in India by the Securities and Exchange Board of India (SEBI). It has established certain guidelines to be followed when executing a buyback programme. These rules aim to ensure transparency, fairness, and the protection of shareholders.

Some key guidelines for share buybacks in India include:

• Buyback Limitations

Companies can buy back up to 25% of their total paid-up capital and free reserves in a financial year. This limit applies to both equity and other eligible securities.

• Minimum and Maximum Prices

For tender offers, the buyback price is usually a premium to the market price. For open market purchases, the company buys at prevailing market prices up to a maximum price specified in the buyback offer.

• Disclosure Requirements

Companies must report the buyback programme to SEBI and the stock exchanges. They must also provide regular updates on the progress of the buyback.

Share buybacks can be a powerful tool for enhancing shareholder value, improving EPS, and managing excess cash. However, they also come with risks, such as increased debt, short-term focus, and the potential for overvaluation. 

It is essential to carefully assess the reasons behind a company’s buyback. The long-term impact should also be considered before evaluating its overall financial position.

This content is for informational purposes only and the same should not be construed as investment advice. Bajaj Finserv Direct Limited shall not be liable or responsible for any investment decision that you may take based on this content.