A share buyback means a company buys their own shares from the market when they want to reduce their number of shares available in the open market.
Share buyback in India – legal provisions
In India, buyback of listed shares was permitted by the Companies (Amendment) Act, 1999 by the insertion of Sections 77A, 77AA and 77B in the Indian Companies Act, 1956.5. The act was introduced along with a set of conditions intended to prevent its misuse by companies and safeguard the interests of the investors. The act proposed that a company can either buy back its shares from existing shareholders on a proportionate basis78 or from the open market, through the book building process or the stock exchange. Indian companies started enacting buyback since 2001 by using both ‘open market repurchase (OMR)’ and ‘tender offer buyback’ mechanism.
There might be multiple reasons companies offer buyback schemes. The company buyback reasons include:
Reasons for buybacks
- They want to reduce the number of shares in the open market.
- The company feels that the share price is undervalued.
- To improve the Company’s Shareholder values.
- To boost share price in the open market.
- The company has additional cash in hand.
1. When shares are overvalued
For starters, buybacks should only be pursued when management is very confident the shares are undervalued. After all, companies are no different than regular investors. If a company is buying up shares for $15 each when they are only worth $10, the company is clearly making a poor investment decision. A company buying an overvalued stock is destroying shareholder value and would be better off paying that cash out as a dividend so that shareholders can invest it more effectively. (Find out what dividends can do for your portfolio in The Power Of Dividend Growth.)
2. To boost earnings per share
Buybacks can boost EPS. When a company goes into the market to buy up its own stock, it decreases the outstanding share count. This means earnings are distributed among fewer shares, raising earnings per share. As a result, many investors applaud a share buyback because they see increasing EPS as a surefire approach to raising share value.
But don’t be fooled. Contrary to popular wisdom (and, in many cases, the wisdom of company boards), increasing EPS doesn’t increase fundamental value. Companies have to spend cash to purchase the shares; investors, in turn, adjust their valuations to reflect the reductions in both cash and shares. The result, sooner or later, is a canceling out of any earnings-per-share impact. In other words, lower cash earnings divided between fewer shares will produce no net change to earnings per share.
Of course, plenty of excitement gets generated by the announcement of a major buyback as the prospect of even a short-lived EPS rise can give share prices a pop-up. But unless the buyback is wise, the only gains go to those investors who sell their shares on the news. There is little benefit for long-term shareholders.
3. To benefit executives
Many executives get the bulk of their compensation in the form of stock options. As a result, buybacks can serve a goal: as stock options are exercised, buyback programs absorb the excess stock and offset the dilution of existing share values and any potential reduction in earnings per share.
By mopping up extra stock and keeping EPS up, buybacks are a convenient way for executives to maximize their own wealth. It’s a way for them to maintain the value of the shares and share options. Some executives may even be tempted to pursue share buybacks to boost the share price in the short term and then sell their shares. What’s more, the big bonuses that CEOs get are often linked to share price gains and increased earnings per share, so they have an incentive to pursue buybacks even when there are better ways to spend the cash or when the shares are overvalued.
4. Buybacks using borrowed money
For executives, the temptation to use debt to finance earnings-boosting share purchases can be hard to resist, too. The company might believe that the cash flow it uses to pay off debt will continue to grow, bringing shareholder funds back into line with borrowings in due course. If they’re right, they’ll look smart. If they’re wrong, investors will get hurt. Managers, moreover, have a tendency to assume that their companies’ shares are undervalued—regardless of the price. When done with borrowing, share buybacks can hurt credit ratings, since they drain cash reserves that can serve as a cushion if times get tough.
One of the reasons given for taking on increased debt to fund a share buyback is that it is more efficient because interest on the debt is tax deductible, unlike dividends. However, debt has to be repaid at some time. Remember, what gets a company into financial difficulties is not lack of profits, but lack of cash.
5. To fend off an acquirer
In some cases, a leveraged buyback can be used as a means to fend off a hostile bidder. The company takes on significant additional debt to repurchase stocks through a buyback program. Such leveraged buybacks can be successful in thwarting hostile bids by both raising the share value (hopefully) and adding a great deal of unwanted debt to the company’s balance sheet.
Issues with share buybacks – Review of literature
- In this blogpost, the author Janet J. Mangano expresses that many academics and politicians question the ethics and values of share buybacks by companies, and how it relates to corporate health and social justice.
- Many people seem to believe that companies usually rely on leverage (debt financing) for share buyback, which is extremely risky. However, this assumption may not be true for non-cyclical industries such as the IT sector. Eg; airline industry is extremely sensitive to business cycles, and in case of economic recession following the buyback, the consequences of that investment are terrible.
- The author of the book also proves how buybacks triggered by the desire to raise the EPS do little to no good in the long run, as substantiated by disadvantage (2) under “When Buybacks Fail” as discussed previously.
- This article raises the same issue of boosting EPS through buybacks as discussed in the previous article, but mentions that even though they can contribute to significant gains when shares are undervalued, they can still be counterproductive.
- The debt financed for buybacks could be put to more productive uses, such as R&D, expansions and for outlays, ultimately benefiting the company in the long run. Therefore, buyback strategy can be termed short-sighted.
“Every dollar spent on buybacks is one less that could otherwise be used on research and development, acquisitions, etc. Management surely could find a more productive use of capital”
This research conducted between 2012-2014 analyzes the stock prices of various companies (samples collected from SEBI and BSE) before, after and during the buyback.
Conclusion: Most of the share prices increased during the buyback than before and after. Finally the open market share repurchase program indicates signaling to investors regarding their share prices.
- Corporate restructuring is a corporate action taken to considerably transform the structure or the operations of a company. Share buyback, in many cases, introduces leverage due to debt financing, and companies may have been trying to restructure capital by changing the debt-equity ratio. Capital restructuring may be it’s primary motive. Z
- The author here expresses that not a lot of research has been done with respect to buy backs in the Indian context and suggests that established companies with moderate growth indulge in buying back less frequently, due to their expansion plans (obviously reinvesting cash flows).
- He also suggests, firms in maturity or decline stage of their life cycle hardly require any capital for their expansion plans and meeting working capital requirements. Consequently, such firms’ payout is higher of their profits and therefore share repurchase initiatives exceed cash dividend payout.
- The paper seeks to look into the reasons for buy back of shares and the value of stakes post the buyback.
- Significant drivers of buybacks were found to be a desire to improve leverage of the companies. Low profitability in large firms also triggered the buyback activity.