Why do companies buy back their shares? - Simplifying the jargon

Chaiwallah of Dalal Street 

I'm starting a series of blog posts that will aim to simplify the stock market jargon. Basically convert the big heavy concepts into simpler sounding words for the layman investor - something that the chaiwallah at Dalal Street would be able to understand & explain to others.

Let's start with share buy backs:

While the stock markets are beating records all around, you might have noticed the recent offers by companies to buy back their shares from shareholders. 

Like you, I was also curious about why companies go in for a buy back of their shares. How does it benefit them? Does it benefit the shareholders as well? Many more questions were swimming around in my head. So I pulled out my trusty mobile phone and did a few Google searches and this is what I found out...

1) Just because a company is initiating a buy back of its shares doesn't mean its a good or a bad thing. You need to see the reasons & the prevailing situations behind it.

2) When a company buys backs its shares, it basically reduces the number of shares in the market. This leads to a rise in the Earnings Per Share (EPS). Quite simply put, if there are fewer shares, that means each share gets a larger portion of the company's profit. So this is a positive move for share holders.

3) Companies usually buy back their shares at a price which is higher that the current market price. So the shareholder selling his share back to the company makes more money. Again, a positive move for share holders.

4) Many a times the company's performance is below par and so buying shares back helps boost the performance on the stock markets, since shareholders can see that the company has confidence in itself and its future performance. At this time, a shareholder has to consider whether s/he believes in the long term prospects of the company and so can stay away from the buy back also hoping to reap better gains in the years to come. This is a neutral point; it'll be positive or negative depending on what the shareholder's view point is about the company.

5) Sometimes companies buy back shares because they have surplus cash which they cannot use anywhere else. It's a way in which companies reward their shareholders.

6) And finally, tax advantage, something that we all try to achieve in multiple ways. Companies in India have to pay a 15% dividend distribution tax. Plus, if the shareholder has an income of more than Rs.10 Lakhs from dividends, then s/he has to pay 10% extra tax. By going in for a buy back, the company is able to transfer benefits to the shareholder without any tax burden (since long term gains are tax free in India). Tax saving is always a positive in anyone's eyes.


So next time a company that you own shares of goes for a buy back, consider all the above points before you decide to be a part of the sale or not.
But remember, whether you're the chaiwallah of Dalal Street or the Big Bull, you need to do some of your own homework (research), weigh all the pros & cons and discuss with your financial planner before you finally decide whether to be a part of the buyback or not.
Because remember, there are never any free lunches!!


I hope this post was helpful. Do share your thoughts in the comments section. Thanks.