Let us look closer

It is a simple idea wherein the company uses its cash surplus to repurchase its own shares from the open market. Since the company cannot act as its own shareholder. When the repurchased shares by the company are absorbed by it, the number of outstanding shares is reduced which in turn increases the EPS. So the outcome of a buyback results in an increase in value for the shareholders.

Improving the financial ratios of the company is also a reason for resorting to buyback. Cash being an asset, a buyback reduces the quantum of cash in the balance sheet and reduces the company’s total asset. As the calculation of ROA - Return On Assets is return / total assets, a decrease in total assets value will show a better ROA figure. Also, a repurchase will result in a reduction in the number of outstanding shares. Since ROE - Return on Earnings is calculated as return/number of shares, a reduction in shares will show a better ROE value. One has to be cautious because, if the company has resorted to buy-back of its shares only to improve its ROE and ROA ratios, then it is not good.

Another issue which a stock buyback seeks to address is to reduce the number of shares in the open market which was the result of stock option plans. While exercising stock options, there is an increase in the number of outstanding shares and makes the ratios of the company look weak – the opposite happens at the time of repurchase. Buyback offers results in a reduction of the company’s book value.

Advantages to the Investor

After a stock buyback, the earning of the company is divided among a fewer number of shares which means a higher EPS earnings per share. In theory, a high EPS commands a higher price for the stock.

Improvement in EPS also results in the P/E of the company getting reduced. A low P/E, and high EPS, ROA, and ROE are considered positive signs for investors.

Stock buyback utilizes the idle cash which will otherwise remain excess. Stock buyback allows the company to transfer extra cash to shareholders without increasing the dividend.

Let us, for example, take the financial figures of ABC company

Before buyback

The total assets and liabilities of the company ABC were 6000 lakhs and 2000 lakhs respectively. The book value of the company, in this case, would be (assets – liabilities) = 4000 lakhs.

Let us assume that the company has 10 lakh outstanding shares, so the book value per share would be (4000/10) = 400 per share.

If the earnings for the year was Rs 350 lakhs, then EPS of the company would be 35 ( 350 /10)

ROE would be 35/400 = 8.75%

Assuming that the shares of ABC were trading at Rs 300 and the company proposes a buyback of 25% of its shares from the market.

After Buyback

The company will need 750 lakhs to buy 25% shares @ Rs 300

The company uses cash of 750 lakhs to buys back the shares. The assets get reduced by Rs 750 to Rs 3250 lakhs.

The number of outstanding shares outstanding gets reduced by 2.5 lakh shares to 7.5 lakhs

New book value will be Rs 1250 lakhs (Rs 3250 lakhs – 2000 lakhs ) so the book value per share = 166.66 per share

EPS = improved from 35 to 46.66 (350 / 7.5)

ROE increased from 8.75% to 27.99 % ( 46.66 / 166.66)

As can be seen, values such as P/E, EPS, RoA, RoE, and others can be boosted up by a stock buyback. Even though fundamentally nothing might have changed for the company, the ratios after buyback will present a better picture. All deficiencies existing in the business before a stock buyback will remain the same even after the buyback or repurchase.

CONCLUSION

Buyback of stock cannot always be a positive indicator. It may not prudent to rush for stock immediately after the announcement of a buyback with an expectation of an increase in prices. It is always better to study the real purpose behind a buyback.