In football, there’s a buyback when a footballer who is being sold to another club has in his/her contract the option for the club that owns him/her to be able to buy back in the future.
Well, this is the financial market and we’ll be looking at the same term which is ‘buyback’.
In this post, we’ll learn about share buyback as it relates to stocks. Let’s get right into it.
What is a Share Buyback?
This is the re-acquisition by a company of its own shares. Share buyback is also known as stock buyback or share repurchase. It represents an alternate and more flexible way (relative to dividends) of returning money to shareholders. When used in coordination with increased corporate leverage, buybacks can increase share prices. In most countries, a corporation can repurchase its own stock by distributing cash to existing shareholders in exchange for a fraction of the company’s outstanding equity; that is, cash is exchanged for a reduction in the number of shares outstanding. The company either retires the repurchased shares or keeps them as treasury stock, available for re-issuance.
Why Share Buyback?
There are 3 major reasons for share buyback. They are:
1. It helps companies consolidate ownership
2. When there’s market pessimism, companies use buyback to increase equity value.
3. Buybacks can make companies look more financially healthy thereby attracting investors.
Methods of Share Buyback
1. Open Market– In this method, the firm will announce that it will repurchase some shares in the open market from time to time as market conditions dictate and maintains the option of deciding whether, when, and how much to repurchase.
Open-market repurchases can span months or even years. There are, however, daily buyback limits which restrict the amount of stock that can be bought over a particular time interval again ranging from months to even years.
2. Accelerated Share Repurchase (ASR)- An accelerated share repurchase (ASR) is a share buyback strategy where a company repurchases a large chunk of its publicly traded equity shares. Companies rely on specialized investment banks to effectuate the transaction.
In a typical ASR transaction, the company delivers the cash up front to the investment bank and enters into a forward contract to have its shares delivered at specified future date, adhering to regulations.
Subsequently, the bank, borrows shares of the company, and delivers those shares back to the company. Companies often engage in accelerated share repurchase (ASR) programs, if they have certain convictions about the intrinsic valuation of the company or if they have commitments of capital return to shareholders.
3. Fixed-price tender- This offer specifies in advance a single purchase price, the number of shares sought, and the duration of the offer, with public disclosure required. The offer may be made conditional upon receiving tenders of a minimum number of shares, and it may permit withdrawal of tendered shares prior to the offer’s expiration date.
Shareholders decide whether or not to participate, and if so, the number of shares to tender to the firm at the specified price. Frequently, officers and directors are precluded from participating in tender offers.
If the number of shares tendered exceeds the number sought, then the company purchases less than all shares tendered at the purchase price on a pro rata basis to all who tendered at the purchase price. If the number of shares tendered is below the number sought, the company may choose to extend the offer’s expiration date.
4. Dutch Auction- This offer specifies a price range within which the shares will ultimately be purchased. Shareholders are invited to tender their stock, if they desire, at any price within the stated range. The firm then compiles these responses, creating a demand curve for the stock.
The purchase price is the lowest price that allows the firm to buy the number of shares sought in the offer, and the firm pays that price to all investors who tendered at or below that price.
If the number of shares tendered exceeds the number sought, then the company purchases less than all shares tendered at or below the purchase price on a pro rata basis to all who tendered at or below the purchase price. If too few shares are tendered, then the firm either cancels the offer (provided it had been made conditional on a minimum acceptance), or it buys back all tendered shares at the maximum price.
Related Content– What is a Shareholder?
Types of Share Buyback
1. Selective buybacks– a selective buyback is one in which identical offers are not made to every shareholder, for example, if offers are made to only some of the shareholders in the company.
2. Employee share scheme buyback- Here, a company may also buy back shares held by or for employees or salaried directors of the company or a related company.
3. On-market buyback- A listed company may also buy back its shares in on-market trading on the stock exchange, following the passing of an ordinary resolution if over the 10/12 limit.
4. Minimum holding buyback– A listed company may also buy unmarketable parcels of shares from shareholders. This does not require a resolution but the purchased shares must still be cancelled.
Issues with Buyback
A stock buyback affects a company’s credit rating if it borrows 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 negatively: They do not see boosting EPS or capitalizing on undervalued shares as a justification for taking on debt. A downgrade in credit rating often follows such a manoeuvre.
Share Buyback Effect on the Economy
Despite the above, buybacks can be good for a company. 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 impact on the financial markets, as they lead to rising stock prices.
But in many ways, the stock market feeds into the real economy and vice versa. For example, research has shown that increases in the stock market positively affect consumer confidence, consumption, and major purchases, a phenomenon dubbed “the wealth effect.”
Another way improvements in the financial markets 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, and fuel improvements in the household balance sheet. Additionally, they increase the chances that consumers can leverage up to borrow to buy a house or start a business.
Conclusion
A company repurchases its shares when it wants to consolidate ownership, preserve stock prices, return stock prices to real value, boost financial ratios, or reduce the cost of capital.
Investors can benefit from stock buybacks because the practice has generally taken the place of dividends. However, there are business drawbacks to stock repurchases, such as possible taxes on the buybacks, a reduction in credit rating, or loss of investor confidence.