Share buy back is described as a procedure that enables a company to go back to its shareholders and offers to purchase from them the shares they hold.
Buy-back of shares, simply stated, is the reverse of raising capital. To start a new business or to expand an existing one or to diversify in to a new area, a company raises money by issuing shares. However, when it earns substantial profits or closes down a particular business and raises money, it pays dividend or returns its capital. In view of the peculiar nature of a company with limited liability, returning capital to shareholders faces far more restrictions than raising capital. Creditors have an assurance that they have the buffer of the paid-up capital for their dues in the sense that losses made by the company will not affect the recovery of their dues so long as such losses do not exceed the paid-up capital. Hence, return of capital, known as “Reduction of capital”, is normally permitted only under sanction of court where the principal concern of the court is that the interests of the creditors are protected. Buy-back of shares makes a departure from this tradition. Companies are now permitted to return capital to the shareholders to a significant though limited extent.
In one sense, buy-back of shares constitutes partial liquidation of the company though, in many cases it simply amounts to a special dividend or even substitution of the regular dividend mainly for perceived tax savings. In a buy-back, the company pays off its dues to the shareholders though an important difference between buy-back and liquidation is that, in buy-back, the amount paid to the shareholders is a mutually agreed price while, in liquidation, the amount proportionately due to each shareholder is paid.2
According to Graham & Dodd in Security Analysis, “A company which buys and sells its stock advantageously, thereby increasing- both the book value per share of the remaining shareholders and, in particular, the earnings per share, has an attraction that goes beyond the basic earning power“. A stock buy-back plan can change a perception of a company that is willing to spend its own money to repurchase outstanding shares. The size of an individual company’s stock buy-back can make a difference in the reaction from the investment world. A stock buy-back of 6 to 8 per cent of the outstanding shares can make investors take notice, while a buy-back of 10 percent or more is often a screaming buy. Stock buy-back programs have two sides to the story. Some view a buy-back program negatively, as skeptics believe the company has no better strategy to use the excess cash. Other times buy-back programs can be viewed extremely positively, as management believes that the company’s stock is a strong buy at current prices. A key caveat is to watch the percentage of shares that are being purchased and not the absolute monetary amount.
Buy-back of shares can be carried out in many ways, though it should be noted that the new law permits it in four specified ways only. Even these face further restrictions by the SEBI regulations.
Before one undertakes buy-back, one need to clearly understand their benefits and implications to determine not only whether the company should undertake buy-back, but also the financial implication including, in particular the implication on cash flow, earnings per share, book value, market price, etc. Determining the buy-back price can be a critical issue particularly when the intention is to have a positive effect on the market price. In some cases, where buy-back is just another form of dividend, other implications may not be important.
The buy-back has the potential of becoming a management, rather than a financial, tool. For, the buy-back reflects a corporate’s faith in its financial abilities, its strategic goals, and its knowledge base. It sends the unequivocal message of value-consciousness to the employee, the shareholder, and the customer. Although such a buy-in into one’s strategy can be cheap–share-prices are ruling at their lowest levels in the last 5 years–there is no denying the fact that the buy-back strengthens the voice of the majority in corporate boardrooms by consolidating shareholdings and quickening response times. In an era where survival has become a pre-occupation, the buy-back has become a potent weapon.
