Demystifying buybacks

By: |
Published: November 4, 2014 4:46:57 PM

Companies buy back shares for many reasons, but there’s just one question you need to answer: Does it benefit you?

A buyback offer is an offer made by a company to buy some percentage of its shares from existing shareholders other than promoters. Companies usually buy back when they feel their shares are undervalued, or when they wish to delist from exchanges. Sometimes, companies with excess cash balance also go for buybacks.

The motive

A company can use the free cash flow for the following purposes: (a) to reduce the debt component in the balance sheet; (b) make an acquisition; or (c) return the cash back to shareholders either as dividends or use it for buyback of shares.

Among the three cited above, option (a) is not always possible because at a given point of time, the company may have attained optimal capital structure and option (b) is feasible only when the company identifies a target company for buyback that will enhance its core competency. Again, this is not a very common phenomenon.

Hence, the most common method for returning free cash flow is stock repurchase or a buyback.

The mechanism

A buyback is proposed and approved by the board and this is communicated to the exchanges where the stocks are listed. A company can buy back its own shares in any of the following ways. It can do so from its existing shareholders through a tender offer, from the open market either through book building or the stock exchange and from odd lot shareholders. Here, an interesting point is that in order to buy back its own shares there is no need to obtain shareholders’ consent if the company proposes a buyback of up to 10% of its paid-up capital and reserves. But if the company proposes a buyback to the tune of 25%, it needs shareholders’ approval.

Participating in the tender offer

Under the tender offer, the company sends a tender/offer form to shareholders. Shareholders who are willing to offer their shares need to fill out the form as per the instructions of the company and enclose the documents asked for. Even those who have not received the tender form but are interested in participating can make an application on plain paper stating the requisite details and tender the same at the collection centres/registrars, as mentioned in the public announcement. In case the shares of the company are tradable compulsorily in the demat segment, the acceptance from any shareholder will be on a proportionate basis irrespective of the number of shares tendered in the buyback, and irrespective of whether shares are in physical or demat form.

If the shares are not in the compulsory demat segment, first, the entire shares tendered, which are less than the minimum market lot, shall be accepted in full. Thereafter, the acceptance will be on a proportionate basis to ensure the acceptances are in the market lot. In such a case, a draw of lots shall be done as in the case of an initial public offer.

The company is required to send an intimation to the tenderers within 15 days from the closure of the offer, and companies are required to send the consideration to shareholders within 21 days from the closure of the buyback offer.

No arbitrage opportunity

Normally, companies declare the price at which they propose to carry out the buy back and the number of shares they will buy back. So, companies will buy back only a certain percentage of their outstanding shares from the public. This is important because many shareholders assume that there exists an arbitrage opportunity in buyback offers, leading to a risk-less profit, which is not true.

Let us understand this with a simple example. For instance, Company ABC comes out with a buyback offer where it states it will buy around 10 lakh shares from the open market at the rate of R115 per share.

This rate is at a 15% premium when the the buyback offer was announced, meaning the prevailing market price for that share is R100. Can you buy the shares at the current market price of R100 from the market and sell them to the company at an assured buyback price of R115 so that you can make a risk-free profit of R15 per share? Theoretically yes, but practically no!

The reason is, normally, there are more shares offered for a buyback than what the company actually wants to buy. In such a scenario, the company buys back the shares in the proportion of the oversubscription.

In such a scenario, only a part of your shares will be bought back and if the price comes down below your purchase price, R100 in this case, then you are either stuck with the remaining shares or book a loss and exit. Hence, in buyback no arbitrage opportunity exists.

To conclude, buyback offers need to be evaluated by shareholders before they tender their shares to the company. Most importantly, note that the arbitrate opportunity of making risk-less profit is absent in buybacks.

The upshot

To buy back its own shares, there is no need to obtain shareholders’ consent if the company proposes a buyback of up to 10% of its paid-up capital and reserves. But if a company proposes a buyback to the  tune of 25%, it needs shareholders’ approval

If the shares are tradable compulsorily in the demat segment, the acceptance from any shareholder will be on a proportionate basis
n many shareholders assume that there exists an arbitrage opportunity in buyback offers, leading to a risk-less profit, which is not true

The writer is associate professor of finance and accounting, IIM Shillong

Get live Stock Prices from BSE and NSE and latest NAV, portfolio of Mutual Funds, calculate your tax by Income Tax Calculator, know market’s Top Gainers, Top Losers & Best Equity Funds. Like us on Facebook and follow us on Twitter.

Switch to Hindi Edition