Share buybacks, also known as stock repurchases, occur when a company uses its own cash or borrowed funds to purchase its shares on the open market. This practice has become increasingly popular in recent years, as companies look for ways to return value to their shareholders. Share buybacks have surpassed dividends as the most popular way to return cash to shareholders.

In this article, we will discuss the reasons why companies undertake share buybacks, the various methods of executing them, and the potential advantages and disadvantages of this strategy.

In a Nutshell

• Why do companies buyback shares?
• Drawbacks of stock buyback
• Share buybacks in Pakistan
• FAQs

Motives behind Buyback Shares

One of the most commonly asked questions is “why do companies buyback shares?” There are various reasons why companies repurchase stocks, let's look at some of them to understand the rationale behind this process.

Increment in Share Value

Share buybacks are often used as a way to return capital to shareholders, as the reduction in the number of outstanding shares can increase the value of each remaining share. One of the primary reasons for the stock buyback is to maximize shareholder return, and buyback increases shareholder value.

Improving an Under Valued Stock

One of the primary drivers behind share buybacks for businesses is the perception that their shares are undervalued. There are various reasons why shares can be undervalued that include:

• Investors' limited ability to assess a company's long-term performance
• Sensationalized news reports
• A general pessimistic market sentiment

A notable example of a historic buyback occurred during the post-Great Recession 2010-2011 recovery in the United States. This was when many companies issued positive outlooks for the future while their stock prices still reflected the earlier economic downturn. In response, some companies opted to reinvest in themselves by repurchasing shares, with the goal of benefiting from an eventual adjustment in stock prices that reflected the improved economic environment.

For instance, a company offers 100,000 shares at a price of Rs.25 per share, resulting in Rs. 2.5 million in equity raised. However, due to a poorly timed news article that casts doubts on the company's leadership ethics, nervous shareholders begin to sell their shares, leading to a drop in the share price to Rs. 15. In response, the company chooses to buy back 50,000 shares at Rs.15 per share, spending a total of Rs. 750,000, and patiently wait for the market volatility to subside.

To Reduce Dilution

A company might opt for shares buyback to curb the dilution that comes from having expansive employee stock option plans (ESOPs). In times of bullish markets and robust economies, the labour market tends to become more fiercely competitive. To retain employees, businesses must compete with attractive compensation packages, which frequently include ESOPs. However, stock options can have the opposite effect of share repurchases by boosting the number of outstanding shares when exercised.

Boost Earning Per Share

Another reason behind stock buyback is that when the number of shares outstanding is reduced, as a result, the earning per share or EPS increases even if its overall earnings remain the same.

Prevents Hostile Takeover

The risk of a hostile takeover is significantly reduced due to stock buybacks. A buyback makes it more difficult for a hostile acquirer to gain control of a company, as the reduced number of outstanding shares makes it more expensive for the acquirer to take a controlling stake.

Disadvantages of Share Buybacks

Despite its evident merits, there are downsides to share buybacks. Lets look at the demerits of a stock repurchase.

Misuse of Funds

The stock repurchase is considered a misuse of funds that could have been useful in the research and expansion of the company. The capital needed to buyback shares could have been used for debt repayment too.

Temporary Boost in Value

While share buybacks can boost earnings per share in the short term, they do not address underlying issues that may be causing the company's stock price to be undervalued. These issues need to be addressed to improve the over fundamentals of a company.

Reduced Flexibility

By using cash or borrowing funds to purchase its own shares, a company may reduce its flexibility to pursue other opportunities or respond to unexpected challenges.

Share Buybacks in Pakistan

Listed companies in Pakistan adhere to the code of conduct for share buyback issued by the Securities and Exchange Commission in Pakistan. Let's explore the most popular stock buybacks in Pakistan.

Share buybacks of leading stocks in Pakistan (Data source: Arif Habib Limited AHL)

Lucky Cement Limit announces a buyback on 24 August 2022. The company decided to repurchase 10 million shares. After the buyback is complete in March 2023, the number of outstanding shares of Lucky Cement will reduce to 313m from 323m after the transaction.

In December 2022, Engro Corporation Ltd. announced a massive stock repurchase. The firm is using the funds to repurchase shares that have experienced a significant decline in price and are now considered to be at attractive levels.

This move is expected to enhance the company's stock prices and valuations while also increasing its share of total profits. As a result of this strategy, Engro Crop's share price rose 2.86% (equivalent to Rs.7.70) to end at Rs.276.72 in December 2022, with a trading volume of 3.45 million shares in a market largely dominated by bears.

Similarly, Kohat Cement, a major player in the cement sector announced a 5 million share buyback in 2023. Textile giant Kohinoor Textile Mills has plans to buy back 30 million shares as well. Bank Al Falah and JDWS have completed their share buyback procedure.

FAQs

What are the methods of executing share buybacks?

There are two main methods of executing a share buyback that include:

• Open market purchases: In this method, the company purchases its shares on the open market, just like any other investor. This method is flexible and allows the company to purchase shares over a period of time, rather than all at once.
• Tender offers: In a tender offer, the company offers to purchase a specific number of shares from shareholders at a premium to the market price. This method can be more expensive than open market purchases, but it allows the company to purchase a large number of shares quickly.

Are stock buybacks better than dividends?

Yes, in some cases, share buyback is an effective way to return capital to shareholders. This way the shareholder does not incur any additional tax on the buyback. Taxes are applicable once the shareholders decide to sell off a share.

Share buybacks can be an effective way for companies to return value to their shareholders and signal confidence to the market. However, they can also be seen as a misuse of funds if the company could have used the money for other purposes, and they do not address underlying issues that may be causing the company's stock price to be undervalued. As with any financial strategy, companies should carefully consider the potential advantages and disadvantages of share buybacks before implementing them.

Knowledge of Capital Market Fundamentals will surely help you fully comprehend the benefits of stock buybacks. And why you should invest in a company that has recently undergone a massive buyback. Similarly, it's also essential to be mindful of Technical Analysis to understand the latest trends, and patterns of everchanging markets.