Corporate stock buyback programmes are popular with investors. Even a statement of a repurchase plan might cause a company’s stock price to rise. Investors frequently assume that the firm sees excellent things happening within the company that are not completely reflected in the stock price, implying that the shares are a steal. But be cautious.
Companies purchase back their shares for a variety of reasons, some of which may be detrimental to shareholders’ interests. Here are a couple of such examples: Increase the stock price. Most equities’ prices tend to be capped via repurchase programmes. This is due to the fact that there is now a significant buyer in the market.
However, corporate assets are being exploited to support share prices. Perhaps the share price would not need to be boosted if management allocated those assets in more productive ways.
- To boost the book value: Book value is calculated by subtracting total liabilities from total assets. A stock buy-back will increase the book value per share, but only if the price paid for the shares is less than the book value per share.
- To Reduce tax: Some people may prefer stock buyback programmes to dividends due to tax considerations. However, it does not explain why a firm or an individual would favour stock repurchases over alternative investments that could produce higher returns than a stock repurchase. In simple terms, dividends are taxed as income, while stock buybacks are not taxed. This means that shareholders can keep more of their money if a company returns cash to them through buybacks rather than dividends.
- To Boost earnings per share: Earnings per share will rise as a result of a stock repurchase programme.
Read: What Are Corporate Actions in Share Market
For example, Tata Consultancy Services Ltd, which trades at Rs 3,500 per share and has yearly profits of Rs 42,300 crores million and 365.91 crore shares outstanding, has an earnings per share of Rs 115.19 and a price-to-earnings ratio of 28.6.
The corporation, which has Rs 13,400 crores in cash on hand, buys back 1% of its shares at Rs 3,500 per share. That equates to 3.65 crore shares or Rs 12,775 crore.
As a result, the same Rs 42,300 crore profit is now distributed across 362.26 crore shares, resulting in earnings per share of Rs 116.76 In effect, earnings increased by 0.57%, the same amount as the number of shares decreased.
The fundamental question about stock buybacks should be, “Is this the best use of your company’s money?” Could the corporation have obtained a higher rate of return if it had invested in something other than its own stock? There is a simple equation you may use to figure this out.
Divide the stock’s price-earnings ratio by 100.
Our company has a price-earnings ratio of 28.6, therefore we end up with 2.86%. If the corporation could invest its assets and earn a higher rate of return (in this case, more than 2.86%), it should not repurchase shares of its own stock. Instead, it should invest Rs 42,300 crore to maximise shareholder returns.
Employee incentive plans: Companies frequently run out of shares to offer as employee incentive choices. If the corporation is buying shares at market value to sell to the manager’s pool of employee incentive options, it could make a compelling case. But it’s not. Shareholders can always authorise additional shares at the next annual meeting.
Hostile takeover defence: Companies with a lot of cash are more likely to be taken over by other companies. If a company spends its cash on buying back its own stock, it has less cash to attract other companies.
