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Why Companies Buy Back ?
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.
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