Last month, PC Jewellers announced buyback of up to 1.21 crore shares worth `424 crore. The board of directors announced that the promoters and promoter group of PC Jewellers will not participate in the proposed buyback. Similarly, Kwality, the dairy products company, has said that its board will consider share buyback at its board meeting on June 20, 2018.
Companies often go for stock buybacks as these are seen as an efficient way to give money back to the shareholders. When a company buys its own shares, it leaves fewer shares outstanding. Such a move boosts earnings per share as the company’s net income is spread over fewer shares. It creates tax benefit opportunities and can push the share prices higher.
Why companies go for buybacks
The company buys its own shares and shows it in the financial statements as treasury stock. It can be sold later if the company decides so. When a company accumulates surplus cash and has no alternative investment opportunities or is not looking at any acquisition, then it can go for buyback of their own shares. This reduces the capital base and results in higher earnings per share. If the company proposes a buyback of up to 10% of its paid-up capital and reserves, then it does not require shareholders’ consent. However, if the company proposes a buyback to the tune of 25%, it needs shareholders approval.
When a company goes for stock buybacks, it is a clear signal that the firm has sufficient cash on hand. Returning excess cash signals to the investors that the organisation feels that it is better to return the cash to shareholders rather than reinvesting in alternative assets. This will support the price of shares and provide long-term security to investors.
Buybacks send a positive signal to the markets as the promoters and management believe that the share is undervalued and the company does not need the cash to cover future commitments such as interest payments and capital expenditures. Retail investors who tender their shares in the buyback get cash benefits now, but will lose out on the long-term benefits in terms of dividends and capital appreciation.
What should investors look at
For any buyback, retail investors should 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 price could be very insignificant.
Investors prefer buybacks over dividends, as these are more tax-efficient. Dividend income in the hands of all residents attracts an additional dividend tax of 10% on dividend income over `10 lakh a year. Also, the effective dividend distribution tax is around 20%.
When extra cash is used to buy back a firm’s stock, instead of increasing the dividend payment, the shareholder gets an opportunity to defer capital gains in case of an increase in share price. Ideally, money from buyback is taxed at the same rate as that on capital gains whereas dividends are subject to the ordinary tax structure.
Returning excess cash makes sense only when the stock is selling for less than its conservatively calculated intrinsic value. In other words, a company’s management should take a rational view of its future business prospects and its stock price. Unless the stock is clearly undervalued, a buyback is the wrong way to go.
Companies declare the price at which they propose to carry out the buyback 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. Investors need to evaluate buyback offers carefully before tendering their shares to the company.