What it means
A share buyback means purchase of outstanding shares by a company from its existing shareholders, usually at a price higher that the market price. When a company buy backs its own shares, the number of shares outstanding in the market reduces, which, in turn, increases the proportion of shares owned by the company. It is a method of cancellation of share capital as opposed to the issue of share capital, which results in an increase in share capital. When a company buys back, the shares are bought by it and not by the promoters; hence the shares bought back are also called treasury stock.
Companies generally go for buybacks when they have a large amount of surplus cash. Such a situation arises when a company is not able to identify suitable projects to invest the surplus cash. In such instances, companies may consider using the surplus cash to buy back their shares. With a buyback, the company may seek to enhance its market price.
A buyback reduces the number of shares outstanding in the market for trading, lowering supply, which may lead to an increase in the stocks price. This is done to project a better valuation of the stock, when the company thinks it is undervalued in the market.
A buyback reduces the shares outstanding in the market, thereby making it difficult for shareholder(s) looking for a controlling stake in the company. Sometimes, a buyback is used as a tool to achieve optimum capital structure.
A company can buy back its shares in any of the following manners:
(a) from existing shareholders, through a tender offer, a portion or all of their shares within a certain timeframe; (b) from the open market through the book-building process; and (c) from odd lot holders.
In all the above cases, the company offers a premium to the prevailing market price. Section 77A of the Companies Amendment Act, 1999, the Sebi (Buy Back of Securities) Regulations and the relevant amendments thereupon document detailed guidelines on the buyback of shares.
Critics of the buyback option claim that many times companies use it to repurchase the entire floating shares in the market with the objective of delisting from stock exchanges, thus eliminating an investment opportunity for investors.
Another argument is that a buyback leads to an increase in compensation packages, which are tied to the earnings per share, a common factor in executives pay calculation.
The debate amongst critics is ongoing, without much empirical evidence to support the theory.
What you should do
The dilemma that investors face is whether the buyback option actually protects their interests and offers them an exit option at a fair price.
As an investor, if you plan to invest in companies that are going to buy back their shares, a word of caution.
One must study the company they wish to invest in and take a decision based on its ability to generate profits. In some cases, buybacks are also announced to trigger certain favourable movements.
It is, therefore, important to look at the size of the buyback offer, the buyback price and the duration of the offer. This is because if the buyback size is very small compared with the overall market capitalisation of the company, the impact on the stock could be little.
The writer is associate professor of finance and accounting at IIM Shillong