Since taxation rules changed on dividends in April 2016 (If the aggregate amount of dividend received by a high net worth individual (HNI) in a financial year exceeds Rs 10 lakh, the amount in excess of Rs 10 lakh becomes taxable) and historically high buyback announcements in the US since December 2017 (Including the latest from Apple), buyback related announcements have come into favor with lots of listed entities.
Investors therefore need to learn how to decide whether to participate in a buyback or abstain.
Buyback is one way through which a company returns a part of the profit it has generated to shareholders. By keeping the buyback price higher than the current market price, it puts some extra money in the pockets of shareholders and indirectly also help shareholders who don’t participate.
When a company buys back shares, its total number of outstanding shares reduces.For the same level of total earnings, if the number of outstanding shares declines, the company generates higher earnings per share (EPS).
Promoters undertake buybacks when they feel the company’s stocks are trading at a price lower than their intrinsic value.
Reasons for Buyback
There are a number of reasons for a listed company to initiate a share buyback:
- The company could have excess cash in its balance sheet but may not have a suitable alternate investment option;
- As a confidence building measure to arrest fall in prices;
- Reduce market cap, thereby improving the issuer’s earnings per share (EPS);
- Lower dividend pay-out to shareholders thereby resulting in lower taxes at the hands of the company;
- Higher return on equity (ROE) leading to higher valuations;
- If the shares are undervalued;
- To prevent or deter hostile takeovers.
Tender offer versus open market purchase
Buybacks can be done either through the tender offer route or through open market purchases. In the former, the company fixes a buyback price and accepts shares on a proportionate basis during the buyback period.
Shareholders will be sent a letter of offer; a form is to be filled in with the necessary details and sent back to the company accompanied by the required documents. Promoters are allowed to tender their shares in this route. Under open market purchases, the company specifies a maximum price and buys back shares from the market during a defined time period. Promoters cannot take part in this route. SEBI (the Securities and Exchange Board of India) has mandated a reservation of 15 per cent of the buyback offer for retail investors with holding of up to 2 lakh (market value as on record date).
The tender offer route is more attractive for shareholders as they know the premium they will get over the market price. In the open market offer, on the other hand, the company only buys when the price dips within the range it has announced.
Should you participate?
The decision to participate in a buyback should depend on a variety of factors.
The former should try to understand the long-term prospects of the company. If the long-term prospects are not healthy, and the company lacks opportunities to grow its business and is then returning money to shareholders in the form of a buyback, assuming the premium is worthwhile, is good for the investor.
The risk herein, of course, is that the prices may not return to current levels.
Acceptance ratio is another important criterion. The company usually stipulates that it will accept only a certain percentage of the shares you own in a buyback.
If the premium announced is small and only a few of the tendered shares are going to be accepted, it may not make sense to go through all the paperwork involved
Jury’s still Out
There is a lot of research going on into whether buyback announcements have any long lasting impact over the trajectory of share prices and the results are mixed. One thing is for sure though – promoters may be , in most cases, using buybacks only as a signal – and therefore each buyback should be properly evaluated before you decide to jump in.