by Mr. P. Saravanan,
IIM Shillong
Share buybacks by
firms are a recent phenomenon that came into practice in 1999, following the
Companies Amendment Act, 1999.
Let us discuss in
detail the concept of buyback, its nuances, the motive and whether an
individual investor should go for it or not.
What buyback means..!
A share buyback means
purchase of outstanding shares by a company from its existing shareholders,
usually at a price higher that the market price.
When a company buy
backs its own shares, the number of shares outstanding in the market reduces,
which, in turn, increases the proportion of shares owned by the company. It is
a method of cancellation of share capital as opposed to the issue of share
capital, which results in an increase in share capital.
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| P. Saravanan, IIM Shillong |
When a company buys
back, the shares are bought by it and not by the promoters; hence the shares
bought back are also called ‘treasury stock’.
The purpose..
Companies generally
go for buybacks when they have a large amount of surplus cash. Such a situation
arises when a company is not able to identify suitable projects to invest the
surplus cash.
In such instances,
companies may consider using the surplus cash to buy back their shares. With a
buyback, the company may seek to enhance its market price.
A buyback reduces the
number of shares outstanding in the market for trading, lowering supply, which
may lead to an increase in the stock’s price. This is done to project a better
valuation of the stock, when the company thinks it is undervalued in the
market.
A buyback reduces the
shares outstanding in the market, thereby making it difficult for
shareholder(s) looking for a controlling stake in the company. Sometimes, a
buyback is used as a tool to achieve optimum capital structure.
The mechanics..!
A company can buy
back its shares in any of the following manners:
(1 ) from existing
shareholders, through a tender offer, a portion or all of their shares within a
certain timeframe;
( 2 ) from the open
market through the book-building process; and
( 3 ) from odd lot
holders.
In all the above
cases, the company offers a premium to the prevailing market price. Section 77A
of the Companies Amendment Act, 1999, the Sebi (Buy Back of Securities)
Regulations and the relevant amendments thereupon document detailed guidelines
on the buyback of shares.
Criticism..!
Critics of the
buyback option claim that many times companies use it to repurchase the entire
floating shares in the market with the objective of delisting from stock
exchanges, thus eliminating an investment opportunity for investors.
Another argument is
that a buyback leads to an increase in compensation packages, which are tied to
the earnings per share, a common factor in executives’ pay calculation.
The debate amongst
critics is ongoing, without much empirical evidence to support the theory.
What you should do..?
The dilemma that
investors face is whether the buyback option actually protects their interests
and offers them an exit option at a fair price.
As an investor, if
you plan to invest in companies that are going to buy back their shares, a word
of caution.
One must study the
firm they wish to invest in and take a decision based on its ability to
generate profits. In some cases, buybacks are also announced to trigger certain
favourable movements.
It is, therefore,
important to look at the size of the buyback offer, the buyback price and the
duration of the offer.
This is because if
the buyback size is very small compared with the overall market capitalisation
of the company, the impact on the stock could be little.
About the author.
The writer Mr. P. Saravanan is associate
professor of finance and accounting at IIM Shillong.
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