From the beginning of this year, more than a dozen companies have either announced or called board meetings for buybacks. During buybacks, the shares are bought back by the company and not by the promoters. Shares that have been repurchased by the company are shown in the financial statements as treasury stock and the same may be sold later if the company decides so.
Why companies go for buyback
Excess cash: When the company has surplus cash and there are no lucrative alternative investment opportunities, then they prefer to go for buyback of their own shares which leads to reduction in capital base and thereby resulting in higher earnings per share.
Defence mechanism: Many companies use buyback as a defense mechanism where the threat of takeover exists. Buyback provides a safeguard against any hostile-takeover attempts by enhancing promoters’ holding.
To send positive signal: Stock market responds to announcements of buybacks because they offer new information about a company’s future. It is a positive signal as the promoters and management believe that the share is undervalued and the company doesn’t need cash to cover future commitments such as interest payments, capital expenditures, etc.
Methods of buyback
A company can buy back its shares in any of the following manners: From the existing shareholders on a proportionate basis through the tender offer and from open market through either book building process or stock exchanges. Under tender offer, the company makes an offer to buy a certain number of shares at a specific price directly from shareholders. This route ensures all shareholders are treated equally, however small they are. In open market purchase, the company decides to acquire a certain number of shares. It fixes a price cap and can buy for any price up to that. Most companies prefer the open market route.
What an investor should do
Should one buy the shares of every company that announced buyback? The answer is big no. Not all buybacks are equal and some buybacks seem to be nothing more than an attempt to increase the share price. It is important to look at the size of the buyback offer, the buyback price and the duration of the offer. The higher the percentage of the buyback, the greater the potential for profits. If the buyback size is too small compared with the overall market capitalisation of the company, the impact on the share could be very insignificant.
Implementation of buyback
There is a time lag between announcing a buyback and actually purchasing of shares by the company. A buyback announcement may initially trigger the price of a share, but when the company actually implement the buyback of the shares that is already factored in the market price and thus the price may not move further up
High stock prices
Sometimes, a buyback programme could be announced when a share is at its life time high. A stock buyback may be used to manipulate its price and earnings per share. One way to cross check this is to compare the price-earnings ratio (p/e) relative to other comparable companies in the sector. If an abnormal ratio exists, it doesn’t make sense for a company to buy its stock at a premium unless there is something big that will add substantially to their earnings. Share buyback scheme takes advantage of supply and demand by reducing the number of shares outstanding thereby increasing the earnings per share, float and the share price. However, not all buybacks are actually implemented so exercise caution and do your own research before embarking into buy the shares of those companies who announce buyback.
(The writer is associate professor finance & accounting, IIM Shillong)