Young Investor

Buyback basics

Anand Kalyanaraman | Updated on February 19, 2011 Published on February 19, 2011

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The recent steep fall in the price of the Reliance Infrastructure stock prompted the company to announce a buyback of its shares. The indicative price for the buyback was much higher than the prevailing market price. A few months ago, Piramal Healthcare also announced a share buyback following the sale of a chunk of its business. What is buyback and why do companies resort to it?



Motivations



Simply put, buyback of shares refers to a company using the cash on its books to repurchase shares (up to limits specified by law) from shareholders. The motivations include returning excess cash to shareholders, sending ‘undervaluation' signals, increasing per share earnings, and raising promoter stake.

A cash-rich company may not see further growth avenues to deploy its resources preferring to return the cash to shareholders through buyback, rather than let it remain idle on its books. With the acquisition price being higher than the market rate, the company portrays the buyback as ‘rewarding' its shareholders , as was seen in the case of Piramal Healthcare.

Buybacks also serve the purpose of boosting per share earnings. Indian corporate law requires that shares bought back need to be extinguished. So, after a buyback, the company will be left with a lesser number of shares, which increases the earnings per share. Buybacks also help companies signal to the market that its shares are trading below what the management perceives to be its intrinsic value. This usually happens in a protracted bear market, or when the shares get hammered due to company specific events and news, as was seen in the recent case of Reliance Infrastructure. The proposal to buyback shares at a higher price is intended to attest the management's confidence about the company's prospects. In any case, a buyback would go through only when it is priced at a premium. Else, shareholders would rather sell in the market, and give the buyback proposal a short shrift.

Also, promoters sometimes use the buyback route to increase their stake in the company at no extra cost to them. This happens when other shareholders give up their shares while promoters hold on to their stake. Promoters get to up their stake with the companies' (and not their personal) funds being used for the buyback.

Do they work?

Clearly, buybacks can be used to kill several birds with one stone. But do they always serve their purpose? Do share prices go up (and stay there), and are shareholders really better off? It has been observed in several cases that the efficacy of price signalling in buybacks is temporary at best. This is mostly observed when the ‘open market' route is used by the company for the buyback. Under this, the buyback resolution ‘allows' the company to acquire ‘up to' a certain number of shares, ‘up to' a certain maximum price per share, ‘up to' a particular date and involving the total outlay of ‘up to' a certain maximum amount.

Now, the proposals may not necessarily be followed through to conclusion by the company, or it may choose to acquire the shares in the open market at a lower rate. Essentially, shareholders may not be able to exit at the ‘maximum' price mentioned in the announcement.

In this context, the ‘tender offer' route of buyback carries certainty on both price and quantum parameters for shareholders. Under this , the company acquires shares directly from shareholders at a fixed price and on a proportionate basis. However, since ‘tender offer' buybacks are not subject to securities transaction tax, they do not enjoy tax benefits on capital gains. In many cases, special dividends may reward shareholders better since they would apply to all shares (and not just a proportion as in the case of buybacks), and are tax exempt for shareholders.

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Published on February 19, 2011
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