Though it can be a risky move in the event that prices stay low, this maneuver can enable businesses who still have long-term need of capital financing to increase their equity without further diluting company ownership.
Buying back stock can also be an easy way to make a business look more attractive to investors. By reducing the number of outstanding shares, a company's earnings per share EPS ratio is automatically increased — because its annual earnings are now divided by a lower number of outstanding shares. Also, short-term investors often look to make quick money by investing in a company leading up to a scheduled buyback. The return on equity ROE ratio is another important financial metric that receives an automatic boost.
One interpretation of a buyback is that the company is financially healthy and no longer needs excess equity funding. It can also be viewed by the market that management has enough confidence in the company to reinvest in itself. Share buybacks are generally seen as less risky than investing in research and development for new technology or acquiring a competitor; it's a profitable action, as long as the company continues to grow. Investors typically see share buybacks as a positive sign for appreciation in the future.
As a result, share buybacks can lead to a rush of investors buying the stock. A stock buyback affects a company's credit rating if it has to borrow money to repurchase the shares. Many companies finance stock buybacks because the loan interest is tax-deductible. However, debt obligations drain cash reserves , which are frequently needed when economic winds shift against a company. For this reason, credit reporting agencies view such-financed stock buybacks in a negative light: They do not see boosting EPS or capitalizing on undervalued shares as a good justification for taking on debt.
A downgrade in credit rating often follows such a maneuver. Despite the above, buybacks can be good for a company's economics. How about the economy as a whole? Stock buybacks can have a mildly positive effect on the economy overall.
They tend to have a much more direct and positive effect on the financial economy, as they lead to rising stock prices. But in many ways, the financial economy feeds into the real economy and vice versa. Research has shown that increases in the stock market have an ameliorative effect on consumer confidence, consumption and major purchases, a phenomenon dubbed "the wealth effect. Another way improvements in the financial economy impact the real economy is through lower borrowing costs for corporations.
In turn, these corporations are more likely to expand operations or spend on research and development. These activities lead to increased hiring and income. For individuals, improvements in the household balance sheet enhance chances they leverage up to borrow to buy a house or start a business.
Share buybacks reduce the company's total number of shares outstanding and the total amount of cash on the company's balance sheet. Those changes affect several metrics used by investors to estimate the value of a company.
Once shares are repurchased, they are generally either cancelled entirely -- wiping them out of existence -- or kept by the company as treasury shares. Treasury shares are counted as issued shares, but not as outstanding shares.
Reducing the number of shares outstanding affects calculations such as earnings per share, which in turn affects a widely used valuation metric, the price-to-earnings ratio. If total earnings stay constant, but the number of shares outstanding falls after a buyback, the company's earnings per share will rise.
Taking that one step further, if the company's stock price stays constant but earnings per share rise, its price-to-earnings ratio will fall. Buybacks also reduce the amount of cash on a company's balance sheet. That in turn increases return on assets , because the company's assets cash have been reduced. Return on equity will also rise, because there's less outstanding equity. While a company's share repurchases are generally intended to be bullish for its stock price, there are sometimes reasons for concern.
Critics often contend, with some justification, that companies tend to repurchase shares after a period of success, when they have plenty of cash. This means that the company is repurchasing its stock at a high valuation. A company in that situation could end up buying its shares at a cyclical price peak , getting fewer shares for its money -- and leaving it with less cash in reserve when its business slows.
Investors should also proceed carefully if the buyback appears motivated by management's desire to improve its valuation metrics or put another way, to manipulate them. 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. 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.
In India buyback is only done through the extinguishing of shares. While the impact on valuations is still debatable, there is no gainsaying that buybacks offer a tax efficient method of returning cash to shareholders! Open an Account.
Learn Blog Details. Lots of cash but few projects to invest in This is one of the primary considerations for companies to buy back shares. The buyback plan is for up to 5. The record date for this has not been set yet. More often than not, share buybacks are led by software services firms. Wipro is a classic example of this. The first buyback that Wipro conducted happened back in May Later in September , Wipro came out with another buyback for repurchasing over Later in June , Wipro came out with yet another buyback to purchase m shares, representing up to 5.
Coming to the most recent buyback of December , Wipro repurchased up to Later in March , Aarti Drugs conducted a buyback of , fully paid up equity shares, representing 1. Two years later, Aarti Drugs again conducted a buyback this year. But this time, the buyback size represented only 0. Later in August , TCS came out with a similar size buyback of up to Under this, it was proposed to buy back up to Four years later in February , the company came out with another buyback program.
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