In recent years, the number of buyback offers has increased. If one casts a glimpse on the data of buyback offers proposed by companies on the Sebi site since 2003-04, two important and relevant points come to surface. First, the sheer increase in the buybacks through the tender offer route (from 2003-2004 till date, buyback through 35 tender offers, 4 open market).
And second, a perceived resultant impact of increase in the shareholders’ or investors’ wealth due to buybacks through the tender route i.e. an option to submit a portion of or all of their shares within a certain time period and at a price usually higher than the current market value.
With few buybacks still to close in the coming months, what is crucial and appropriate to gauge are whether buyback offers are judicious ways to increase one’s wealth and if they are, what the right factors in the presence of which one must accept a buyback offer are.
The intricacies
A buyback entails taking back of shares by the company from the investors at a specified price; this offer can be binding or optional to the investors. Explains Harjit Singh Sethi, CEO, Almondz Securities, “The basic objective of a buyback offer is to reduce the equity capital. However, it is an effective, indirect way of rewarding the shareholders.”
Primarily a buyback takes three routes:
a) Tender offer: Shareholders are presented with an offer where they have the option to submit a portion of or all of their shares within a certain time period and at usually a price higher than the current market value.
b) Through book-building process.
c) Companies can buy shares from the open market over a long-term period subject to guidelines issued by market regulator. In these methods it is important to be wary of facts that are behind the buybacks, which more than often go unnoticed.
An enticing price offer and the combination of many other factors colour the vision of the investor for the long term. And the reason for this can be found from a relatively accurate question: why the buyback offer?
Says Manish Sonthalia, vice-president, equity strategy, Motilal Oswal, “One must understand that the cost of equity is far more expensive than debt. Hence, if a company has free reserves and if it can’t generate good returns, it is better to give back the money of the shareholders and therefore, it is sensible to come out with a buyback offer.”
In the right situations
It is prudent to assess the company’s motives in proposing a buyback offer. Observes Sonthalia of Motilal Oswal, “An appropriate time to jump at a buyback offer is when you see the price quoted is more than the value of the business. To be more accurate, if the price offered captures the full potential of the business.”
Also, you must take a look at the share price movement immediately before the buyback. If there has been a linear and consistent increase rather than a significant rise, the prima facie assumption is that the promoters are quite determined about the buyback offer.
Because there could be instances where some promoters would misuse the buyback concept and declare shocking results. Consequently, when share prices are depressed, they will come out with a buyback offer, a bit less than the intrinsic value, thereby increasing their stake in the company at the expense of the shareholders. Because such buybacks reduce equity base but increase the EPS (earning per share). This would result in an increase in share prices.
Another factor is the fundamentals of a company. It would be difficult to envisage whether a company would issue bonus or split shares or make an acquisition. But these factors can be sidelined if the fundamentals of the company are strong and you expect the company to perform well in the future. Therefore, with a long-term perspective, the scrips of such companies should not be sold.
However, if these factors don’t prevail, it is advisable to sell off.
It is seen that despite strong fundamentals, the shares of a few companies are highly volatile and exhibit wild oscillation in prices. If you want to play it safe and avoid volatility, selling out would be a better option. One needs to take into account the promoters’ holding in the company.
Emphasises Muthuraman Mudliar, vice-president-equity, of a leading broking firm, “One must also consider the promoter holding while accepting a buyback offer. Promoters having more than 90% holding have no obligation to be listed on the exchange. A case in the point is the recent Essar Steel buyback.”
Adds Sonthalia of Motilal Oswal, “If the company gets delisted, its shares have no value and hence investors must assess whether the company is in the process of getting delisted and if it is, there is no point accepting the offer and offload it in the secondary market.”
Finally, accept a buyback if the company’s managers choose to participate in the buyback themselves. When managers elect to sell shares rather than retain them, it suggests that they do not believe in their own estimates of value. In addition to these factors, you also need to watch out developments, which may coax you to accept a buyback, and the repercussion of which you wouldn’t be able to figure out.
To watch out for
A crucial thing to watch out for in a buyback is to evaluate whether a company has a chunk of unused cash. If it does have, with not many new profitable projects to invest in, then it is an issue. Also, you need to assess the company’s debt-equity ratio. It is seen that companies, which are highly indebted, are unlikely to have free cash.
Advises Sethi of Almondz Securities, “It makes sense for an investor to keep an eye on a turnaround company. In such cases, it is recommended not to opt for the buyback, instead hold on to the shares to reap the fruits of its growth.”
It is also paramount to assess whether the buyback offer is to bring in liquidity in the stock. An offer with a huge premium may appear very attractive. You need to ensure that any temporary negatives do not affect the share price. If you feel that the share prices are currently undervalued, refrain from selling, since a company buying back its shares is indirectly conveying that its shares are undervalued.
It is seen that in order to show rosier financials companies try to use buyback. For example, when a company uses its cash to buy stock, it reduces outstanding shares and also the assets on the balance sheet (because cash is an asset).
Thus, return on assets (ROA) actually increases with reduction in assets, and return on equity (ROE) increases as there is less outstanding equity. If the company earnings are identical before and after the buyback, EPS and the P/E ratio would look better. And if EPS and P/E figures in most investment decisions show an improvement could jump-start the stock. For this strategy to work in the long term, the stock should truly be undervalued. You need to watch out for such cases.
Buyback offers are also used to increase promoter’s stake. Some companies buy back shares to contain the dilution in promoter holding, EPS and reduction in prices arising out of the exercise of ESOPs. This leads to increase in outstanding shares and drop in prices. This also gives scope to takeover bids as the share of promoters dilutes.
For instance, technology companies, which had issued ESOPs during the dot-com boom in 2000-01, had to buyback after exercise. This was done to ensure a cap in drop of promoters’ holding.
Actually, buybacks affect value in two ways. First, the buyback announcement, its terms, and the way it is implemented all convey signals about the company’s prospects and plans. Second, when financed by a debt issue, buybacks can significantly change a company’s capital structure, increasing its reliance on debt and decreasing its reliance on equity.
You must interpret a company’s decision of buy back through the lens of past experience and in its current context. Buybacks can also backfire for a company competing in a high-growth industry because they may be read as an admission that the company has few important new opportunities on which to otherwise spend its money. In such cases, long-term investors will respond to a buyback announcement by selling the company’s shares. However, investors sensing this can explore the markets for a better price to the share than the proposed price offer of the company.
Gauge the difference
In fact, even after the buyback is announced, the purchase price need not necessarily be the highest if a price band is given. Further, there is no guarantee that all the shares offered for buyback would be bought. In such cases to be compensated at a fair price, it would be wiser to sell your stake in the market at a time when prices of your scrip are trading at a price equivalent to the highest in the offer band. The secondary market allows the option to exit a business at a price, which the market estimates is a fair value of the equity share.
However, at times, market estimates may not reflect the true value of an equity share. But by selling in the secondary market the shareholder is knowingly exposed to the risk of not being compensated at the fair price. One would assume that the company has a ‘fairer’ estimate of the value of its business, though this perception on a few occasions is incorrect.
The reason being: suppose a resolution approved by shareholders is for re-purchasing of a company’s shares at a maximum price of Rs 303 and not ‘only at’ Rs 303. This could indicate that the company is a buyer only if its share trades below Rs 303 for a ‘reasonable’ period of time. This could create an artificial support price with the market aware that a buyer exists below the indicated price.
Also, assuming that Rs 303 represents the fair value of the share the management wants to compensate the shareholder, at a price below fair value. A case in the point is Reliance Energy buyback. The company proposed a buyback of equity shares at a maximum price of Rs 525 per share, even though the share price was quoting at Rs 540.05.
This is outrageous. Hence it is of prime importance to assess opportunities in the markets as well. Buyback as such may give you a fair value, perceived accordingly by the company, but you may end up garnering more in the markets, which may be the real fair value of the share than the fair value perceived by the company.