Finance / Fundamental Analysis / Investments · February 4, 2022

5 Reasons Why Companies Buy Back Their Own Shares

Introduction

Public companies that are traded on the stock market have collected money from the people of the country in exchange for a part of company ownership.

They take money from the public against part company ownership. In case of a buy back, the company pays back the money to the investors and takes back the equity.

What is buy back of shares

Buy back is a process when a company takes back its equity from the stock market that is available in the public domain.

When a business buys its own outstanding shares, it reduces the number of shares accessible to the open market.

The company may either opt for complete buy back or partial buy back. In the case of completely buy back of shares, the business then turns back into private limited company. On the other hand, in the case of partial buy back the corporate increases it promoter holding.

Reasons that influence companies to buy back their own shares

When companies are under valued for a long time

There are times when the company is growing extremely well in numbers but there isn’t any correspond increase in the share price.

Year on year the financial performance is growing at a good rate but the same output is not getting reflected on the value of stock price.

This may be due to the lack of awareness in the particular niche. The reason for the stock price to go up or down is purely dependent on the demand and supply of free shares available to trade.

Since there isn’t price movements, the stock tends to trade with low volatility. Thus, when the company buys back the shares from the open market in large volumes, the price of the company spikes up.

This also bring a focus on the company and the general investors. They enter the market to grab the opportunity to buy these shares at fair valuations.

Using the cash reserves to buy equity

Companies that are well established and have business set on automation, are in no need to use up the profits. In this case, the company may decide to use the surplus cash to buy back the company.

When the company makes profits and fills its reserves. As a result, decides to buy back the shares at market valuation. This is does as the firm have no other plans to expand the business in any way possible.

In this case, the company regains the major portion of the equity and can thus enjoy the gains accumulated in the future.

Confidential development

When the company is traded on a stock exchange, it becomes a public company. This puts an obligation on the company to share all its financial status and other details to the general public.

There can arise a scenario wherein the future the company may not be comfortable to share it financial statement in order to protect the interest of the promoters or the business itself.

Also the companies that are traded on stock market are closely monitored by SEBI (Securities Exchange Board of India). SEBI ensures that the internal execution of the firm is intact. This also put an obligation on these companies to follow a set of rules and regulations as directed by SEBI from time to time.

These companies at a particular point in time may decide not to involve a third party monitoring and choose to go back as a private company.

Back to privatizing the company

At certain point in time the company can decides that it does not want to stay public anymore and need to privatize the company. In that case it needs to buy off all the equity shares floating in the market.

This can be due to the internal decisions of the promoters who may not be comfortable to share the financial statement of the company.

Reducing the number of free shares in the market

When the free shares in the open market get reduced, there will be a scarcity of the shares. This scarcity will then create a demand for the shares. This spikes up the volatility of the share price.

A spike in volatility can imply high dips and fall in the market price which can facilitate good entry and exit points for the stock.

Conclusion

Buy back of shares may be a complicated process for the companies. They may not directly disclose the reasons for the buy back.

As per my experience, any company will only buy back if they know some inside secrets like huge profits, declaration of dividends, or a new corporate deal.

Also Read: What Is The Difference Between Intrinsic Value And Market Value

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