Buy-Back is a corporate action in which a company buys back its shares from the existing shareholders usually at a price higher than market price. When it buys back, the number of shares outstanding in the market reduces and hence the market capitalisation as per below relation:
Market capitalisation = Market value * Number of shares outstanding
From a corporate point of view what could be a better investment than investing in its own shares. But why would a company invest in itself is what many of us will ponder about. Here is the answer!!
Firstly, consider a company which possesses huge cash reserve but has no upcoming projects to invest into. In that case the company may plan to invest in itself and offer the existing shareholders an option to sell their shares to the company at an attractive price. It is similar to reinvesting its cash in itself which also aims at bringing in dilution in the markets as outstanding shares in the market are reduced.
Secondly, a company may also go for buybacks with an aim of projecting better valuation of their stocks when they think it is undervalued in the market. The reason is companies buy its shares at higher price than current market price which indicates that its worth in the market is more than the present value. This in turn shoots up company’s stock prices post buy back.
Thirdly, some companies may also use it as a tool to change their capital structure i.e. debt-equity ratio in specific. By buying back the shares from open market, a company may increase its reliance on the debt financing rather than equity financing. Moreover interest payment on debt is tax deductible. So after tax cost of debt is quite lesser than shareholders return on equity.
Fourthly, companies also go for buyback with intent of projecting better financial ratios as indicated below:
EPS: Earnings per share = Earnings/ Shares outstanding
Since outstanding shares reduce, the company’s earnings are now divided amongst less number of shares for calculating EPS value. From investor’s point of view, higher the earnings per share, better it is as an investment option. Thus even though the earnings of a company are still the same, but EPS value post buyback is increased.
RoA and RoE
When a company buys its stock, the cash assets on its balance sheets reduce. This increases the return on the assets value. And further due to reduction in the outstanding shares in the market, the RoE value also shoots up.
This is all about the company’s intent of investing its cash in itself, but from the investor’s perspective, buybacks are most of the times euphoric. The reason is : either they will end up making profit by selling them to company at an attractive price or it leads to higher stock price due to reduction in outstanding shares in the open market . But as a common investor, what one should be careful about is the fundamentals of the company going for any corporate action.
Legally, The provisions regulating buy back of shares are contained in Section 77A, 77AA and 77B of the Companies Act, 1956. These were inserted by the Companies (Amendment) Act, 1999. The Securities and Exchange Board of India (SEBI) framed the SEBI(Buy Back of Securities) Regulations,1999 and the Department of Company Affairs framed the Private Limited Company and Unlisted Public company (Buy Back of Securities) rules,1999 pursuant to Section 77A(2)(f) and (g) respectively.