Buyback basics

The spotlight has picked out buybacks in the past few days, with public sector companies which are sitting on mountains of cash being asked to effect buybacks. What is buyback? Why do companies resort to it?

A buyback is quite literally buying back of shares by a company. It uses the cash it has to purchase a specified number of shares from its shareholders. The cash in hand reduces to the extent utilised while the shares bought back are extinguished, leaving the company with a smaller shareholder base. When you, as a shareholder, participate in a buyback, the action is similar to exiting a stock.

Why buyback?

Motivations for companies to initiate buybacks are many. For instance, it's a method of rewarding shareholders by returning excess cash to them. This is usually done when a cash-rich company doesn't see good growth avenues to deploy its resources. It prefers to return the cash to shareholders rather than let it idle around. Acquisition price in such cases is usually higher than the market price, from where the ‘rewarding shareholders' concept emerges.

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. Further, because buybacks reduce the number of outstanding shares, it serves the purpose of boosting per share earnings. Note that a company's sales and profits haven't actually improved. It's just the EPS which has gone up by virtue of a smaller base.

Yet another reason to effect buybacks is to counter the threat of a hostile takeover. Through a buyback, a company can mop up outstanding shares from the open market which makes it harder for another to take control. Buybacks can sometimes be used to send ‘undervaluation' signals to the market, indicating that a company's shares are trading below what the management perceives to be its intrinsic value.

How they work

A buyback can be done through a couple of ways. The first is through a tender offer, where the company makes an offer to buy a certain number of shares at a specific price directly from the shareholders. Usually, a period within which a shareholder must accept the offer is specified. Such a proportionate buyback ensures equal treatment to all shareholders, whether majority or minority.

The other route is to make purchases in the open market where the company acquires ‘up to' a certain number of shares, ‘up to' a certain price for a share, ‘up to' a particular date and involving the total outlay of ‘up to' a certain amount.

This method is where the actual benefit to a shareholder cannot be accurately judged since the company could have bought shares at a lower rate. It isn't possible to always exit at the ‘maximum' price which the company is willing to buy. The company simply provides updates on the number of shares bought.

In this context, the tender offer route carries certainty on both price and quantum parameters. A company can also purchase shares issued under an employee stock option scheme. In any case, though buybacks are meant to support stock prices or generate interest in them, the run up in prices is, more often than not, only temporary. That's one reason why you should never enter a stock based on a buyback announcement hoping to pocket easy gains.

A call on whether or not to participate in a buyback is much like deciding when and why you sell a stock. Always base decisions on the business strength of the underlying company.

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