Buybacks are just the opposite of share issues. While a company raises money from the public when it issues shares, at the time of a buyback it pays its shareholders in order to reduce the number of its shares outstanding.
The motives
Companies buyback their own shares for a variety of reasons. The first is to instil confidence in their shareholders when its share price is witnessing a free fall. With this step, the company's management tries to convey the message that the company's shares are available at a discount compared to its intrinsic value. And since the management has confidence in its company, it is using the cheap valuations to buy up shares. The freefall could be happening for any reason. For instance, during 2008 the share prices of a lot of companies had fallen to very low levels because the macro-environment as a whole was bleak then.
The other reason why companies go for buybacks is to increase the value of their shares. Since buybacks are done at a premium (to prevailing market price), investors who want to sell out get a good price. Meanwhile, the number of outstanding shares gets reduced. This results in higher earnings per share (EPS) on same level of profits. This usually drives the company's share price up, thereby rewarding existing shareholders. Sometimes companies also engage in buybacks as a means of deploying their excess cash holdings. Various studies have shown that when a company with excess cash goes on an acquisition spree, in the majority of cases it fails to create shareholder value. Thus, besides paying out dividends, buybacks are a good way of rewarding shareholders. At times a buyback is also done in order to reduce the dilution caused by generous employee stock option plans (ESOPs) and warrant conversions.
What needs to be remembered is that a buyback helps shore up a company's share price only if its fundamentals are sound. Otherwise the buyback provides only temporary support and its stock price and its effect soon wears off.
A catch with many buyback programmes is that they are announced but not implemented right away, making it difficult for existing shareholders to benefit from them. Existing shareholders should decide to avail a company's buyback offer based on their assessment of its prospects. If these are sound, they should stay on as they too stand to benefit from the buyback.
