What are stock buybacks?

Many companies regularly buy back their own stocks in the stock market. Among the big ones, Wipro Ltd bought back shares worth Rs 12000 Crores back in June this year, and BSE Ltd is set to buy back shares worth Rs 375 Crores later this month. Even Apple, the biggest public company in the world, regularly buy back their shares.

Share or stock buyback is a situation when companies decide to purchase their own share from existing shareholders either through a tender offer or through an open market. Because buybacks are carried out using the company’s retained earnings, they can be looked at as a way to reward the existing shareholders apart from dividends.

So why do these companies conduct this activity? Why not just leave everything as it is and spend their cash on new products or services?

• Excess Cash: When companies have more cash than they can invest in new projects and it does not even make sense to hold that much in their coffers, they can decide to reward their shareholders by initiating buybacks, because, after all, shareholders are all part owners of the company.

• To signal that shares are undervalued: If a company buys back its shares, it means they would rather spend their cash on buying these shares instead of somewhere else, meaning they are thinking they are getting them for cheap. If they had considered them expensive (in terms of price vs. value), they would not buy the shares back.

• Consolidating/Retaining Control: Companies often award their employees in terms of stock options/ESOPs. To offer these things, the company can buy back shares from shareholders so that they can avoid the dilution of the other shareholders. This can also be used by board members to maintain their control over the company and secure their voting rights.

When a stock buyback occurs, a few things change in terms of the financials. Obviously, the number of outstanding shares decreases. Due to that, the Earnings Per Share (EPS) increases: even if the earnings or income (numerator) is kept the same and the denominator is decreasing, the resultant EPS increases.

The company’s cash on hand decreases, therefore assets decrease. But shareholders’ equity also decreases. Both these facts mean metrics like Return on Assets (ROA) and Return on Equity (ROE) increase, and signify better business conducted by the company.

The company’s image also gets better. If they are capable of buybacks and believe in the business enough to do so, both existing and potential investors would be attracted to the company.

Now, critics can also put forth decent arguments against buybacks. A company with downward momentum can also initiate buybacks if they don’t have any new prospects at all. A company’s management could even use buybacks as a way to boost share prices and increase their pay in the form of stock options.

My recommendation is to definitely look into the company’s business and not buy their shares blindly after a buyback announcement. Even if a company’s intentions are all good, and they buy back shares, there is no guarantee their shares would rise quickly, your investment could still take years to go into profit.

So what do you think? Are buybacks completely good or bad? Or do they lie in some grey area in between? Anyway, if you enjoyed this article, you can read more from me here. And do let me know if you want a specific topic covered. Subscribe for free to receive more posts like this every day!