Last week, the board of directors of Tata Consultancy Services (TCS), India’s largest information technology services provider, approved a proposal to buy back up to 76 million equity shares to the tune of 16,000 crore. The buyback price has been fixed at `2,100 a share, a 15% premium over its current market price. The buyback is around 2% of the total paid-up capital. This is the second year in a row when TCS has decided to go for buyback of shares in a bid to return excess cash to its shareholders.
Last year, the company bought back 56.1 million shares at `2,850 each. As per the records of Securities and Exchange Board of India (Sebi), during the last six months, 34 companies have announced and gone ahead with their buyback across sectors such as cement, pharmaceutical, etc. Let us understand why companies go for buyback of their own shares and as a shareholder when one should sell their shares to the company under buyback scheme. Rationale for buyback Often companies go for buyback in order to use the excess cash generated by the business. Having excess cash costs not only the company but also shareholders as cash is a kind of a ‘non-earning asset’.
The company could park the excess cash in short-term instruments but that would fetch very little return. Further, a buyback announcement could send a positive signal to the stock market that the management have enough confidence in the future performance of their company. Better control over the company Under buyback, the company (not the promoters) is buying back its own shares with the excess cash generated by the business. One could see this as an indirect way of enhancing the controlling stake in the company. The shares bought under this schema are being kept by the company and shown in the balance sheet as a treasury stock. This could be used for employee stock option scheme or even it could be resold whenever the need arises. By means of buyback the promoters indirectly increase their stake in the company.
Mechanics of buyback A company could go for buyback in two ways. One is through open tender offer from the existing shareholders on a proportionate basis. Second is from open market through either book building process or stock exchanges. However, majority of the companies like to go through the open market route. Evaluation Buyback can improve the financial ratios such as earnings per share, price earnings ratio, etc. However, not all buyback offers are good. There is empirical evidence available across countries and markets that sometimes buybacks are a short-cut way to increase the price. As an investor, one should look at the size of the buyback.
If the buyback offer is too small, say 0.25% of market capitalisation of the company, the effect owing to buyback could not be that much. Time gap Often, there is a time gap between announcement of a buyback and actual implementation. Generally, a buyback announcement may trigger the price of a share, but when actually the company implements the buyback the steam in the market might be gone or the effect might be already factored into the price and so the price may not go up further. Many investors see buybacks as a tax-efficient way of returning the cash to the shareholders against the option of paying dividends. One should note that buyback has no impact on the fundamentals of the company in the short term and thus investors need to consider the above factors while evaluating buybacks.
The writer is professor of finance & accounting, IIM Tiruchirappalli