Buy-back of shares is an action under which a company listed on the stock market buys back its shares from the existing shareholders which is usually at a price higher than the current market price of the share of the company. Any company buys back its own shares to increase the proportion of shares by reducing the number of shares outstanding in the market. Buy back helps the company to comparatively increase value of the undervalued stocks. Any company can buy back its own shares only from 3 sources that are allowed by the companies (amendment) act 1999 that are 1. Free reserves 2. Securities premium account 3. Proceeds from the sale of any stocks or other specified securities. However, the proceeds of a previous offering of the same type of shares cannot be used to fund a buyback of shares. The buyback of shares are carried out for a variety of reasons:
- Buy-back helps a company to boost the share prices of their undervalued stocks. The stock buyback reduces the number of shares in the market that thus increases price of the remaining shares.
- Excess cash in the business that is not invested in any projects promotes the buyback of shares. The company would prefer to reward the shareholders and increasing the value of the business rather than keeping it idle in the bank account.
- Buybacks are a tax efficient method of rewarding the shareholders. Company rewards shareholders by paying out dividends that are taxable both in the hands of shareholders as well as the company. Buyback of shares helps them rewarding the shareholders as well as saving the tax in paying out the dividend.
- There are different business models which have different capital structure. Capital structure is represented by debt-equity ratio. Some business models require large debt base to run their business, buybacks can help them reduce the equity base of the business thus achieving the optimum capital structure.
Although a buy-back may appear to be the greatest condition for a company, it does have a disadvantage.:
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- Reduces the cash surplus within the company. The much-needed cash by a company that acts as a cushion for the company in tough times is substantially reduced.
- The management might wrongly value the share price of their company under a bias approach that might show the overvalued share as an undervalued share. In this situation buy back is not a good option to pursue.
- Buy back uses the funds that can be used by the company to more productive projects to increase the earning of the company. However, the company's finances are diverted from profitable investments when it buys back stock.
- Buy backs may misrepresent the financial ratios of the company like Earnings per share (EPS), Return on assets (ROA), Return on Equity (ROE) not giving a fair view of company.