MEANING OF BUYBACK OF SHARES
A corporation's repurchase of stock or bonds it has issued. In the case of stocks, this
reduces the number of shares outstanding, giving each remaining shareholder a larger
percentage ownership of the company. This is usually considered a sign that the company's
management is optimistic about the future and believes that the current share price is
undervalued. Reasons for buybacks include putting unused cash to use, raising earnings per
share, increasing internal control of the company, and obtaining stock for employee stock
option plans or pension plans. When a company's shareholders vote to authorize a buyback,
they aren't obliged to actually undertake the buyback. also called corporate repurchase.
A stock buyback, also known as a "share repurchase", is a company's buying back its
shares from the marketplace. You can think of a buyback as a company investing in itself, or
using its cash to buy its own shares. The idea is simple: because a company can't act as its
own shareholder, repurchased shares are absorbed by the company, and the number of
outstanding shares on the market is reduced. When this happens, the relative ownership
stake of each investor increases because there are fewer shares, or claims, on the earnings
of the company
OBJECTIVE OF BUYBACK OF SHARES
Shares may be bought back by the company on account of one or more of the following reasons
Unused Cash: If they have huge cash reserves with not many new profitable projects to
invest in and if the company thinks the market price of its share is undervalued. Eg. Bajaj
Auto went on a massive buy back in 2000 and Reliance's recent buyback. However,
companies in emerging markets like India have growth opportunities. Therefore applying this
argument to these companies is not logical. This argument is valid for MNCs, which already
have adequate R&D budget and presence across markets. Since their incremental growth
potential limited, they can buyback shares as a reward for their shareholders.
Tax Gains Since dividends are taxed at higher rate than capital gains, companies prefer
buyback to reward their investors instead of distributing cash dividends, as capital gains tax is
generally lower. At present, short-term capital gains are taxed at 10% and long-term capital
gains are not taxed.
Market perception By buying their shares at a price higher than prevailing market price
company signals that its share valuation should be higher. Eg: In October 1987 stock prices
in US started crashing. Expecting further fall many companies like Citigroup, IBM et al have
come out with buyback offers worth billions of dollars at prices higher than the prevailing
rates thus stemming the fall.
Exit option If a company wants to exit a particular country or wants to close the company it
can offer to buy back its shares that are trading in the market.
Increase promoter's stake Some companies come out with buy back proposal to increase
the stake of promoters, as the shares that are purchased from market (under buy back) are
scrapped. Thus increasing the stake of promoters
Escape monitoring of accounts and legal controls If a company wants to avoid the
regulations of the market regulator by delisting. They avoid any public scrutiny of its books of
Show rosier financials Companies try to use buyback method to show better financial
ratios. For eg. 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 earnings per share (EPS) and the P/E ratio would look better even though earnings
did not improve. Since investors carefully scrutinize only EPS and P/E figures, an
improvement could jump-start the stock. For this strategy to work in the long term, the stock
should truly be undervalued.
Generally the intention for the buyback is a mix of any of the above reasons.
Sometimes Governments nationalize the companies by taking over it and then compensates
the shareholders by buying back their shares at a predetermined price. Eg. Reserve Bank of
India in 1949 by buying back the shares.
ADVANTAGES AND DISADVANTAGES OF BUYBACK OF SHARES
Increase confidence in management: It might enhance the confidence of its investors on
the company's board of directors, as these investors know that the directors are ever willing
to return surplus cash if it's not able to earn above the company's alternative investment or
cost of capital.
Enhances shareholders value: Generally, share buybacks are good for shareholders. The
laws of supply and demand would suggest that with fewer shares on the market, the share
price would tend to rise. Although the company will see a fall in profits because it will no
longer receive interest on the cash, this is more than made up for by the reduction in the
number of shares.
Higher Share Price: Buying back stock means that the company earnings are now split
among fewer shares, meaning higher earnings per share (EPS). Theoretically, higher
earnings per share should command a higher stock price which is great!
Reduce takeover chances: Buying back stock uses up excess cash. The returns on excess
cash in money market accounts can drag down overall company performance. Cash rich
companies are also very attractive takeover targets. Buying back stock allows the company
to earn a better return on excess cash and keep itself from becoming a takeover target.
Increase ROE: Buying back stock can increase the return on equity (ROE). This effect is
greater the more undervalued the shares are when they are repurchased. If shares are
undervalued, this may be the most profitable course of action for the company.
Psychological Effect: When a company purchases its own stock it is essentially telling the
market that they think that the company's stock is undervalued. This can have a
psychological effect on the market.
Buying back stock allows a company to pass on extra cash to shareholders without raising
the dividend. If the cash is temporary in nature it may prove more beneficial to pass on value
to shareholders through buybacks rather than raising the dividend.
Excellent Tool For Financial Reengineering: In the case of profit making, high dividend-
paying companies whose share prices are languishing, buybacks can actually boost their
bottom lines since dividends attract taxes. A buyback and the subsequent neutralisation of
shares, can reduce dividend outflows, and if the opportunity cost of funds used is lower than
the dividend savings, the company can laugh all the way to the bank.
Stock buybacks also raise the demand for the stock on the open market. This point is rather
self explanatory as the company is competing against other investors to purchase shares of
its own stock.
Sending Negative Signals: A buyback announcement can send a negative signal in these
situations. A typical example is the HP case: From November 1998 through October 2000,
the computer giant Hewlett-Packard spent $8.2 billion to buy back 128 million of its shares.
The aim was to make opportunistic purchases of HP stock at attractive prices—in other
words, at prices they felt undervalued the company. Instead of signaling a good operating
prospects to the market, the buyback signal was completely drowned out more powerful
contradictory signals about the company's future which are an aborted acquisition, a
protracted business restructuring, slipping financial results, and a decay in the general
profitability of key markets. By last January, HP's shares were trading at around half the
average $64 per share paid to repurchase the stock.
Backfire: 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.
The share buyback scheme might become a big disadvantage to the company when it pays
too much for its own shares. Indeed, it is foolish to buy in an overpriced market. Instead, the
company should put the money into assets that can be easily converted back into cash. This
way, when the market swings the other way and is trading below its true value, shares of the
company can be bought back at a discount; ensuring current shareholders receive maximum
benefit. Strictly, a company should repurchase its shares only when its stock is trading below
its expected value and when no better investment opportunities are available.
PROVISIONS / CONDITIONS RELATING TO BUYBACK
The restrictions were imposed to restrict the companies from using the stock markets as short
term money provider apart from protecting interests of small investors.
Sec 77A: Power of a company to purchase its own securities.
Section 77A was introduced by the Companies (Amendment) Act, 1999, pursuant to the report of
the working group which was set up to suggest reforms to the Companies Act.
Section 77A(2) of the Companies Act, 1956:
Authorised by Articles of Association and a Special Resolution
Buyback should be equal to or less than 25%of the total paid up capital and free reserves
Shares to be bought back should be fully paid up
Debt Equity ratio should not exceed 2:1 post buyback
Notice of meeting to the shareholders should have all the details necessary
Buyback of shares listed on any recognised stock exchange should be in accordance with
Explanatory statement stating the following should be prepared-
A full and complete disclosure of all material facts;
The necessity for the buy-back;
The class of security intended to be purchased under the buy-back;
The amount to be invested under the buy-back; and
The time limit for completion of buy-back
A declaration of solvency has to be filed with SEBI and Registrar Of Companies
Completion of the buyback should be within 12 months
The shares bought back should be extinguished and physically destroyed;
The company should not make any further issue of securities within 2 years, except bonus,
conversion of warrants, etc.
METHODS OF BUYBACK
There are a number of ways in which a company can return wealth to its shareholders. Although
stock price appreciation and dividends are the two most common ways of doing this, there are
other useful, and often overlooked, ways for companies to share their wealth with investors.
Typically, the two ways of buyback are:
Tender Offer. Shareholders may be presented with a tender offer by the company to
submit, or tender, a portion or all of their shares within a certain time frame. The tender offer
will stipulate both the number of shares the company is looking to repurchase and the price
range they are willing to pay (almost always at a premium to the market price). When
investors take up the offer, they will state the number of shares they want to tender along with
the price they are willing to accept. Once the company has received all of the offers, it will
find the right mix to buy the shares at the lowest cost.
Open Market. The second alternative a company has is to buy shares on the open market,
just like an individual investor would, at the market price. It is important to note, however, that
when a company announces a buyback it is usually perceived by the market as a positive
thing, which often causes the share price to shoot up.
Book-building process. Companies can also use the book building process to buy back
shares. The book building process is a mechanism of price discovery which helps determine
market price of securities. If the book building option is used, a draft prospectus has to be
filed with SEBI. The prospectus should contain all the details of the offer, except the price at
which the securities will be offered (a price band is specified). The copy of the draft
prospectus is filed with SEBI and is circulated among institutional buyers by a leading
merchant banker acting as the book runner. Institutional investors specify the price as well as
the volume of shares they intend to buy. The book runner, on receiving the above
information, determines the price at which the offer is to be made to the public.
In both 1 & 3 promoters can participate in buyback and not in 2.
Other methods of buyback are
Employee-share purchases - purchases of shares held by or for the benefit of current or
former employees of a company, including salaried directors, according to the terms of
an employee share scheme
Odd-lot purchases - purchases by listed companies of small parcels of shares which are
not marketable on the stock exchange. Here odd lots, that is to say, where the lot of
securities of a public company, whose shares are listed on a recognized stock exchange,
is smaller than such marketable lot, as may be specified by the stock exchange; or
Selective buy-backs - a buy-back that does not fall within any of the other categories,
such as the purchase of a particular member's shares.
The best example of such a buyback in the Indian context was the buyback of shares undertaken
by the Great Eastern Shipping Company (GESCO) to protect itself from a hostile takeover bid led
by the A H Dalmia group. In October 2000, the A H Dalmia group of Delhi made a hostile bid for a
45 per cent stake in the Great Eastern Shipping Company (GESCO) at Rs. 27 a share. The price
offered was less than half the book value of the company. The offer and counter offers made by
the A H Dalmia group and the promoters of GESCO pushed up the bidding cost. The A H Dalmia
group ultimately sold its 10.5% stake (around 3 million shares) at Rs 54 per share for a
consideration of Rs. 163 million before the year end. The A H Dalmia group had acquired the
10.5% stake in Gesco at an average cost of Rs. 24 per share for a consideration of Rs. 72 million.
Hence, the A H Dalmia group was able to make a profit of Rs. 91 million through greenmail
transaction in less than 6 months