Is stock buyback effective for shareholders?

Stock buyback, also known as share repurchase, refers to repurchasing of shares or the stock by the same company that issued them.

Stock buyback, also known as share repurchase, refers to repurchasing of shares or the stock by the same company that issued them. Companies do buyback to repay all the excess cash to the shareholders. Buyback allows companies the chance to reinvest in their own companies by reducing the total number of outstanding shares available on the market. Share repurchasing is carried out either on the open market, the same way how investors purchase stock and/or through the tender offer route.

When a company buys shares of its own stock and retires them, it leaves fewer shares outstanding. This boosts earnings per share, because the company’s net income is spread over fewer shares. It creates tax benefit opportunities and can push the share prices higher.

When a stock repurchase is announced, the issuing firm intends to redeem some or all of its outstanding stocks that were earlier issued to raise equity capital. At the time of buyback, shareholders are remunerated the equal market value of the stock. Repurchasing outstanding shares help organizations reduce its capital cost, consolidate ownership and benefit from temporary undervaluation of stock.

The most convenient interpretation of a company stock repurchase is that the organization is doing good financially and doesn’t need equity funding anymore. Instead of bearing the burden of unnecessary equity, the company reduces its average capital cost and refunds shareholders’ capital. Stocks buybacks are often seen as an efficient way to give money back to the company shareholders. Here are some of the benefits of buying back shares:

Increase shareholder’s value

There are a lot of ways to value a profit running organization, but the most popular measurement is EPS (Earnings Per Share). EPS is typically viewed as the most important variable to determine share prices. It is the segment of an organization’s profit allotted to each outstanding share of common stock. When organizations pursue share buybacks, they generally reduce the assets on their balance sheets and raise their return on assets. Similarly, by diminishing the total number of outstanding shares, and keeping the level of profitability intact, EPS will shoot up. Shareholders who keep their shares will have a higher percentage of ownership of the organization’s share and the price of each share will be higher. Those who sell the shares, sell it at a price they are comfortable with.

Tax efficient

When extra cash is used to buyback firm’s stock, instead of increasing the dividend payment, shareholder gets an opportunity to postpone capital gains in case of an increase in share price. Ideally, buyback is taxed at a tax rate of capital gain whereas, dividends are subject to the ordinary tax structure. If the stock is kept for over a year, the profit is not taxable as it comes under Long Term Capital gains tax, which presently is nil.

Returning excess cash

When companies indulge in stock buyback programs, this indicates to the investors that the firm has sufficient additional cash on hand. Returning excess cash signals to the investors that the organization feels that cash is better used to return cash to shareholders instead of reinvesting in alternative assets. This supports the price of shares and provides a long-term security for the investors.

Returning excess cash makes sense only when the stock is selling for less than its conservatively calculated intrinsic value. In other words, a company’s management should take a rational view of its future business prospects and its stock price. Unless the stock is clearly undervalued, a buyback is the wrong way to go.

Redistributing wealth to investors is a positive move. This can be in the form of dividends, retained earnings or stock buybacks. While stock buyback is important for financial stability, an organization’s fundamentals and track records are also important for long-term value creation.

The writer is founder, Prudent Equity

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