Buyback is a reverse of issue of shares by a company. The company offers to take back its shares owned by the investors at a specified price. The price can be binding or optional to the investors. Buybacks have increased this year due to the decline in markets from all-time high. A depressed market is a ripe time for promoters to mop up shares at low prices without using personal funds.
There are many reasons why companies choose to buy back shares. Investors should study the reasons behind the company’s buyback strategy before tendering their shares. If companies have huge cash reserves with not many new profitable projects to invest, buyback is a way to reward investors. However, companies in emerging markets like India have growth opportunities. So this logic does not apply.
Many companies use buyback to show better financial ratios. Thus, return on assets (ROA) actually increases with the reduction in assets, and return on equity (ROE) rises as there is less outstanding equity. The earning per share (EPS) and the P/E ratio looks better after the buyback on reduced capital even though the earning may not improve. As investors scrutinise EPS and P/E before investing, the favorable ratios could boost the stock.
Some companies buy back stock to contain the dilution in promoter holding and EPS from the employee stock option plans (ESOPs). Any such exercise leads to increase in outstanding shares and drop in prices. This also gives scope for takeover bids as the share of promoters reduces.
Buyback is another strategy to maintain the share price in a bear run. By buying shares at a price higher than the prevailing market price, the company signals that its share valuation should be higher, thus stemming the fall. The stock repurchase program reaffirms the confidence the company has in its long-term growth and profitability, and demonstrates its commitment to enhance shareholder value by rewarding investors.
Buyback also has certain negative implications. Buyback sends signals that the market capitalisation of the shares has scope to improve and, thus, leads to speculative activities.
Second, the promoters’ holding increases subsequent to the capital reduction with the use of company funds. This is a setback for investors who stay put in the company, particularly in the growth sectors. A reduced capital decreases the borrowing power. If buyback is resorted to by incremental borrowings, the increased cost of capital proves to be detrimental to the company’s health. The financial flexibility of the company is curbed, consequently restricting the developmental process and may even prove fatal in contingencies, which cannot be ruled out in a business.
Buyback also prevents the company from raising equity capital for the next two years. This could impact the company’s growth process as it may not be able to use opportunities that may arise in the following two years for diversification, modernisation or expansion.
There are certain checks and balances investors must apply before participating in a buyback. Companies generally tend to buy back shares at a higher premium over the market price if they feel that their shares are under-priced. This decision to buy back often leads to increase in the share price. Investors should look at the share price movement immediately before the buyback. If there has been a significant rise, the assumption is that the promoters have been up to some manipulations.
Companies with huge debts are unlikely to have free cash. So investors should check the debt-to-equity ratio of the company. Companies that have just come to the capital markets to raise money are unlikely to be good candidates for buyback. When the management has passed special resolutions, with a lot of publicity, empowering the board to decide on the buyback date, there is scope for suspicion.
If investors feel the share price is undervalued, refrain from tendering the shares, as the company buying back the shares is indirectly conveying that its shares are undervalued. Despite strong fundamentals, the shares of a few companies are highly volatile and exhibit wild oscillation in prices. If investors want to play it safe and avoid volatility, selling out would be a better option. Decide to sell the scrip when the market price is equivalent to the highest in the offer band.
When a company announces a buyback, it is usually perceived by the market as a positive, which often causes the share price to shoot up. In one sense, this is good for shareholders because the dividend payout per share rises. On the other hand, it is an acknowledgement that the management can think of nothing better to do with company’s money than buy back its own shares. If a stock is undervalued and a buyback truly represents the best possible investment for a company, the buyback — and its effects — can be viewed as a positive sign for shareholders.
Watch out if a company is merely using buyback to prop up ratios to provide short-term relief to an ailing stock price or to get out from excessive dilution. The reward to the shareholders should be equitable and without discrimination and there should be no protection to one class or group of shareholders at the cost of other.
Buyback has provided MNCs the option to convert their Indian ventures into whollyowned subsidiaries, delist their shares and take complete control over their Indian ventures, and make decisions that could be detrimental to the interest of minority investors.
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