A buyback in the case of financial markets refers to that process where the company purchases shares or stocks from the shareholders in the market. Buyback of shares is a strategy used by the owners of the company to send a signal to the shareholders of the company about their confidence in their own company. In order to understand more about the process let’s look at some of the advantages and disadvantages of buyback –
Advantages of Buyback
- The biggest advantage of buyback is that it helps the company in enhancing the confidence of shareholders in the owners of the company because the fact that the owners are buying their own stock is an indication by the management that company in the future will be doing good as the biggest insiders of the company are the owners themselves and if they are buying their own stock than it is an indication that they expect the price of stock to rise in future.
- Another benefit of the this process is that it helps the company in using excess cash which was lying idle with the company because excess cash earns no income and if the company has not enough opportunities for expansion than it can use that excess cash for buyback of stocks.
- Another merit of the this process is that it reduces the chances of the takeover of the company by other companies because due to the buyback of shares promoter stake increases and higher the promoter stake less likely are the chances of a takeover by other companies.
Disadvantages of Buyback
- The biggest disadvantage of buyback is that cash used by the company to buyback the stocks has opportunity cost because that excess cash could be used by the company for variety of productive activities like starting new manufacturing plant, increasing the marketing expenditure to boost sales, recruiting new people in the company and so on which in turn can result in increase in profits of the company. Hence if the company is going for buyback it is overlooking all the other alternatives in which cash can be used.
- Another drawback of the this process is that sometimes it may be used by the promoters to give a false signal about the company so as to increase the price of stocks so that promoters can sell their stocks. Hence investors should be wary of those companies where promoter’s history is questionable because when the news of buyback comes into market domain the price of the stock rises which can be a trap for innocent investors.
- Another disadvantage of this process is that many people view it as a sign that company has no profitable opportunity in the current business and that is the reason why they are using excess cash for buyback of stocks which creates negative image about the company in minds of long-term investors who are looking for capital appreciation due to growth in the company.
As one can see from that buyback has both advantages, as well as disadvantages and any company thinking of buyback, should carefully analyze the above point and then take the decision accordingly.