Stock prices of a company are affected by any positive or negative news of the company or material changes in the capital or debt structure as well. Threw are many corporate actions that impact the capital structure of the company and the buyback of shares is one such event. Recently, there have been many buyback offers by multiple companies like ACC Limited, Bajaj Auto Limited, etc. and a buyback offer from Infosys has been approved by its Board to be announced shortly. But what is the meaning of buyback and why do companies announce it? And more importantly, is it good news for investors?
Given below is a brief discussion answering all these questions.
Read More: Dividend-vs-Buyback; Which is beneficial?
The simple meaning of buyback of shares is when a company buys its own shares from the existing shareholders. The offer for the buyback is usually at a price higher than the market value which makes it more attractive for the investor. The original draft of the Companies Act, of 1956 did not have any provision for the buyback of shares by a company. However, many companies wanted to go ahead with the option of buyback for various reasons, and therefore, this provision was added to the Act after the President issued an ordinance to this effect along with an amendment to the Companies Act.
A company opting for a buyback of shares will have to adhere to various provisions of the Companies Act 2013. These provisions relate to the permissible funds that can be used for the buyback of shares under section 68 and section 69. As well as the specific conditions under which a company is permitted to proceed with the buyback.
A company can proceed with the buyback of shares by offering it to the public in any of the following two ways.
- Through tender method
Under this format, the buyback offer is offered to the shareholders at a particular price or a fixed price and the offer is open for shareholders for 10 working days. The company has to mandatorily provide a Letter of Offer and the buyback is usually done on a proportionate basis of the total shares offered for buyback (unless there are not enough shareholders willing to opt for buyback)
- Through open market
Under this format of the buyback offer, the company purchases shares from the open market and there is no concept of the record date or buyback on a proportional basis. This type of buyback can be open for a maximum period of 6 months or till the time that the target buyback size of the company is met whichever is earlier.
A company can initiate a buyback offer for various purposes. Some of the common reasons for a buyback are highlighted hereunder.
- Improving the EPS
The buyback offer requires the company to purchase back its shares from its existing shareholder. Such shares are then extinguished within a period of 7 days from the completion of the buyback offer. This results in a reduction in the number of outstanding shares in the company. Therefore, the available net profit will be divided among fewer outstanding shares thereby improving the EPS.
- Increase promoter shareholding
The promoters of the company are the persons in charge of initiating the company and they have a significant stake in the same. However, over time they may have to face erosion of their stake making the company vulnerable to hostile takeovers. The shareholders may also be too fragmented over the years further stressing the need to consolidate the stakes. In such cases, through a buyback, promoters can increase their stake in the company and have a better hold on the same.
- Paying surplus cash back to the shareholders
A buyback is a good option for a company that is flush with cash but does not have any lucrative projects to invest in. Through a buyback, the company can make better use of the available cash by giving the shareholders better returns on their investments as well as fixing their financial statements by adjusting their surplus cash towards building value for the company.
- Undervalued shares
The news of the buyback indicates a positive sign for the company. It instills confidence in the investors that the promoters have a bright view of the company’s future. Furthermore, the announcement of a buyback also signals that the promoters view the company shares to be undervalued and want to bring them to better valuations.
- Tax effective for shareholders
Apart from the buyback offer, another option for disbursal of available profits and cash reserves to the shareholders is through dividends. However, dividends are taxable in the hands of investors as per the amendment to Finance Act 2020. On the other hand, buybacks have no tax implications on the investors making them more lucrative than dividends.
The impact of the buyback of shares is multifold and can be seen in various entities. The details of the same are mentioned below.
- Impact on financial statements of a company
The direct impact of the buyback is on the financial statements of the company. The balance sheet of the company will reflect two major changes on the asset side and the liabilities side. The cash reserves of the company will reduce post the completion of the buyback and on the liabilities side, the shareholder’s equity will take a hit. With the reduced number of outstanding shares, the EPS of the company will see an increase benefiting the shareholders post-completion of the buyback
- Impact on the share price
The news of the buyback creates a positive buzz for the company’s shares and they see a general rise in its demand in the open market. Even after the buyback is completed the outstanding number of shares available in the market is reduced. The EPS of the company also increases post-buyback which further fuels the stock prices as the demand for the shares is higher than its supply.
- Impact on the reputation of the company
The reputation of the company sees a positive impact with the announcement of a buyback. It tells the shareholder and potential investors that the promoters are positive or optimistic about the company’s financial future. This confidence is also trickled into the shares prices and has a favourable impact on the same.
Conclusion
Buyback is a very effective tool for capital restructuring and improving key financial ratios of the company which in turn has a positive impact on the share prices. It is an attractive offer that allows investors to gain from selling their holdings. However, investors should ascertain whether such a buyback is a favorable option by analyzing the fundamentals of the company to check if staying invested is a better option than opting out of their holdings in such a company.
FAQs
Section 70 of the Companies Act, 2013 provides for certain conditions under which a company is not permitted to buy back its shares. These conditions state that,
-A company cannot directly or indirectly purchase its own shares or other securities through any subsidiary including their own subsidiary
-A company is also prohibited from buyback of its shares through an investment company or a group of investment companies.
-A company that has defaulted and continues to default in repayment of any loans and/or interest thereon, the redemption of debentures, repayment of term deposits and/or interest on the same, dividend payments, etc.
As per section 68 of the Companies Act, 2013, the maximum permissible limit for the buyback is up to 25% of the paid-up equity capital in any financial year.
The shares bought back under the buyback scheme have to be extinguished and physically destroyed within a period of 7 days from the last day of completion of the buyback.
Capital Redemption Reserve is created when buyback is through the company’s free reserves and/or its securities premium received by such a company. In such cases, the company has to allocate an equivalent to the nominal value of shares bought back towards the Capital Redemption Reserve. This reserve will then be used only for the issue of fully paid bonus shares.
