Understanding Share Buybacks

Published by Sharekhan Education | May 4, 2021

Understanding Share Buybacks

What is a Buyback?

Buyback is a corporate action through which the company can repurchase its outstanding shares for cash payment to the shareholders whose shares get accepted in the offer. When it buys back, the number of shares outstanding in the market reduces, thereby increasing the proportion of shares a promoter owns. It is a way of rewarding the shareholders for remaining invested with the company.

There are two ways to carry out buyback:

1. Tender offer
2. Open Market offer

Tender offerd

The tender offer is a process in which the shareholders of the company can offer full or partial shares in the buyback. Companies typically announce buybacks at prices higher than the current market value. The premium gained by tendering the shares is a reward for the shareholders for holding the shares. In a tender, three main things are specified – the buyback price, duration of the offer, and the number of shares the company wishes to buyback. The company buys only the required amount of shares and returns the rest to the shareholders in case the shares tendered are much higher. This buyback is proportionate buyback. If the number of shares tendered is less then what the company wants to buyback, then the company will usually extend the time for which the offer would remain open and try to get the requisite number of shares. The buyback through a tender offer is an alternative form of dividend distribution.

Open Market offer:

In this process, the company purchases shares through the stock market. It decides beforehand the maximum price (the buyback can be done up to or below this price and not beyond this price), the duration of the buyback, and the amount of money it intends to spend on the buyback. However, the process creates uncertainty about the number of shares that the company will buy back, as the price can be below or up to the maximum price. The buyback can continue over an extended period or at certain times at regular intervals.

When does a company do a buyback?

1. The company initiates a buyback when it believes that the current share price undervalues the shares.
2. Buyback of shares can increase the earnings per share (EPS) of the company as the number of shares reduces and price of the shares go increases; assuming valuation (PE ratio) that company enjoys remains the same. However, the price increase is beneficial to shareholders only when the increase in the price of shares compensates for the reduction in profits by the amount of other income that could have been generated by investing the cash elsewhere.

3. The company can initiate a buyback when it believes it has excess cash and cannot deploy it in projects, businesses, or investment vehicles that offer high returns on investments.

4. Companies also conduct share buybacks to support share prices during sluggish market conditions.
   Reservation for small retail shareholders:

In a buyback, 15% of the offer is reserved for small retail shareholders who holdup to Rs. 2 lakhs worth of shares.  The buyback announcement may attract more shareholders, potentially increasing the number of small retail shareholders. Their participation in the tender offer could then reduce the number of accepted shares.

For example, the buyback is to be done for 10,00,000 shares of which 15% (1,50,000) is reserved for small shareholders.  Let us say before announcing the offer, the small retail shareholders hold 2,00,000 shares. Assuming all shares are tendered in the offer, the company accepts 75% of them. However, after the announcement, small retail shareholders buy more shares, increasing the total in this category to 3,00,000. If all shares in the small retail category are tendered in the buyback, the company will accept only 50% of them.

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