The Motives

Let's take a look at why a company would initiate such a plan. If you ask a
firm's management, they'll likely tell you that a buyback is the best use
of capital at a particular time. After all, the goal of a firm's management is to
maximize return for shareholders and a buyback generally
increases shareholder value. The prototypical line in a buyback press
release is "we don't see any better investment than in ourselves." Although
this can sometimes be the case, this statement is not always true.

Nevertheless, there are still sound motives that drive companies to

repurchase shares. For example, management may feel the market has
discounted its share price too steeply. A stock price can be pummeled by the
market for many reasons like weaker-than-expected earnings results, an
accounting scandal or just a poor overall economic climate. Thus, when a
company spends millions of dollars buying up its own shares, it can be a sign
that management believes that the market has gone too far in discounting the
shares - a positive sign.

Improving Financial Ratios

Another reason a company might pursue a buyback is solely to improve its

financial ratios - metrics upon which the market seems to be heavily focused.
This motivation is questionable. If reducing the number of shares is not done
in an attempt to create more value for shareholders but rather make financial
ratios look better, there is likely to be a problem with the management.
However, if a company's motive for initiating a buyback program is sound, the
improvement of its financial ratios in the process may just be a byproduct of a
good corporate decision. Let's look at how this happens.

First of all, share buybacks reduce the number of shares outstanding. Once a
company purchases its shares, it often cancels them or keeps them
as treasury shares and reduces the number of shares outstanding, in the
process.

Moreover, buybacks reduce the assets on the balance sheet (remember cash
is an asset). As a result, return on assets (ROA) actually increases because
assets are reduced; return on equity (ROE) increases because there is less
outstanding equity. In general, the market views higher ROA and ROE as
positives.

Suppose a company repurchases one million shares at $15 per share for a
total cash outlay of $15 million. Below are the components of the ROA
and earnings per share (EPS) calculations and how they change as a result of
the buyback.
As you can see, the company's cash hoard has been reduced from $20 million
to $5 million. Because cash is an asset, this will lower the total assets of the
company from $50 million to $35 million. This then leads to an increase in its
ROA, even though earnings have not changed. Prior to the buyback, its ROA
was 4% ($2 million/$50 million) but after the repurchase, ROA increases to
5.71% ($2 million/$35 million). A similar effect can be seen in the EPS
number, which increases from 20 cents ($2 million/10 million shares) to 22
cents ($2 million/9 million shares).

The buyback also helps to improve the company's price-earnings ratio (P/E).
The P/E ratio is one of the most well-known and often-used measures of
value. At the risk of oversimplification, when it comes to the P/E ratio, the
market often thinks lower is better. Therefore, if we assume that the shares
remain at $15, the P/E ratio before the buyback is 75 ($15/20 cents); after the
buyback, the P/E decreases to 68 ($15/22 cents) due to the reduction in
outstanding shares. In other words, fewer shares + same earnings = higher
EPS which leads to a better P/E.

Based on the P/E ratio as a measure of value, the company is now less
expensive per dollar of earnings than it was prior to the repurchase despite
the fact there was no change in earnings.

Dilution

Another reason that a company may move forward with a buyback is to

reduce the dilution that is often caused by generous employee stock option
plans (ESOP).

Bull markets and strong economies often create a very competitive labor
market - companies have to compete to retain personnel and ESOPs
comprise many compensation packages. Stock options have the opposite
effect of share repurchases, as they increase the number of shares
outstanding when the options are exercised. As was seen in the above
example, a change in the number of outstanding shares can affect key
financial measures such as EPS and P/E. In the case of dilution, it has the
opposite effect of repurchase: it weakens the financial appearance of the
company.
Continuing with the previous example, let's assume, instead, that the shares in
the company had increased by one million. In this case, its EPS would have
fallen to 18 cents per share from 20 cents per share. After years
of lucrative stock option programs, a company may feel the need to
repurchase shares to avoid or eliminate excessive dilution.
Attempt to boost earnings per share (EPS): One of the common reasons
why companies go for share buyback is to boost earnings per share
(EPS), because share buyback reduces outstanding shares in the
market. Let’s understand this with the help of any example.
Company XYZ announces a share buyback program to repurchase, let’s
say, 10 per cent of the outstanding shares at current market price.

The company had Rs 10,00,000 in earnings spread out over 1 million

shares, or 10,00,000 shares, equating to EPS of Re 1.
EPS = Total Earnings/Total number of shares.

Let’s say with a PE of 30, the shares traded at Rs 30.

Market price = P/E X EPS.

Now, all else being equal, if 100,000 shares are repurchased, the new
EPS would be Total Earnings/Number of shares, which in this case
would become 10,00,000/9,00,000= Rs 1.11. Now, at a PE of 30, the
shares would trade up by (1.11 x 30) = Rs 33.30

Reward shareholders
Undervalued shares:
Lack of growth opportunities
Tax advantage