In this blog, I will discuss the key terminologies related to a stock buyback; definition, the reason why a company goes for buyback, benefits of buyback and what an investor should if offered a buyback. Read on!
In this article
- What Is A Stock Buyback?
- What Is The Immediate Impact Of A Buyback?
- Why Don’t Investors Participate In The Buyback?
- How Does Buyback Differ From Promoter Buying Shares?
- What Is The Record Date In Buyback?
- How to Tender Shares For Buyback?
- What Is The Acceptance Ratio In Buyback?
- Reasons Why Companies Go For A Buyback
- Conclusion: What Should You Do If A Buyback Is Offered?
What Is A Stock Buyback?
A stock buyback is a method by which a listed company buys its shares form the market using the cash generated from the business.
What Is The Immediate Impact Of A Buyback?
Buyback results in increasing ownership for the shareholders who do not tender their stocks for the buyback. This is because the total number of outstanding (floating) shares reduces, thereby reducing the denominator.
Let us see an example –
A company XYZ ltd has 1000 shares of Rs 100 each. The shares are traded at Rs 120 in the market. Two investors (Mr. A and Mr. B) owns ten shares (1% of the company). The company announced a buyback of 100 shares at a higher price than Rs 120.
Mr. A sells his stock to the company, while Mr. B doesn’t sell his holding.
After the transaction, the 1000 shares become 990 shares, thereby resulting in the holding of Mr. B increasing from 1% to 1.01%.
Why Don’t Investors Participate In The Buyback?
Generally, long-term investors tend to not participate in the buyback program because after the buyback, the ownership percentage of investors (who have not participated) increases (refer to our example above).
Thus, not participating could be a good option for promoters and large shareholders and is an excellent way to increase their holding in the company.
In promoter buying shares, the promoters (individuals and/or businesses, including family office) use their own funds to repurchase the shares. On the other hand, the buyback is executed with the available cash with the company.
Promoters (through his personal account or the family office) buy the shares from the market like any other investor does and tends to increase his/her holding in the company. The act doesn’t reduce the denominator, i.e., the total outstanding number of shares of the company like it decreases in the buyback.
Also, in promoters buying shares, the earnings per share for the company doesn’t change as the number of shares does not change. On the other hand, in the buyback, since the number of shares reduces, there is a corresponding increase in the earnings per share. Thus, it leads to a decline in Price to Earning Ratio (P/E), thereby making it attractive for investments.
Therefore, one would generally see a slight surge in the price of the shares whenever a company announces buyback.
What Is The Record Date In Buyback?
Shareholders for a public listed company keeps regularly changing due to the continuous transactions in exchange. Thus, it is essential to set a date so that a company can decide on the eligibility of the shareholders who can tender their shares for the buyback.
Thus, the record date is the date as on which every shareholder would be eligible to tender his/her holdings for the buyback. To qualify, the shares need to be held in the Demat form in the account of the shareholder as on the record date.
If an investor/trader is looking to gain some quick capital gain, need to ideally buy a stock of the company (who announced buyback) at least two (2) days before the record date to be eligible for buyback and quick gain.
This is because it takes T+2 days for shares to be deposited in the Demat account.
The process of tendering shares for buyback differs from broker to broker. However, at a comprehensive level, the process remains flow remains the same.
The shareholder is required to fill the form (that is prefilled in several aspects) with the details of the number of shares held, the number of shares entitled to a buyback, to tender, number of shares offered for buyback, and the likes.
The Registrar and Transfer Agents (RTAs, typically Karvy Computershare, etc.) send the official email communication with the information such as time limit to fill the form and submit it.
Once the form is submitted, the shares in the Demat account is reduced by the number of shares offered for the buyback. An investor can sell the remaining in the market.
For the shares tendered for repurchase, once the RTA completes the verification process, the buyback amount gets credited in the bank account linked to the Demat account.
What Is The Acceptance Ratio In Buyback?
It is one of the most critical aspects of buyback and is represented as the ratio of the tentative amount of the shares that will be accepted for buyback to the total number of shares on offer by the shareholders. The ratio (often expressed as a percentage) is commonly used as an essential tool to decide on the tendering of shares.
Also, it is essential to note here that the acceptance ratio computation is not very straight forward, as mentioned above. This is because the market regulator Securities and Exchange Board of India (SEBI) tries to provide importance to retail shareholders and thus mandates higher acceptance from the bucket.
Reasons Why Companies Go For A Buyback
A company may decide to go for the buyback for one or more of the reasons listed below :-
1.Availability Of Surplus Cash But Limited Scope Of Investment.
One of the primary reasons why a company goes for a buyback is the availability of surplus cash but limited areas/projects to invest in.
Typically IT companies such as Infosys, Tata Consultancy Services, HCL, have a huge surplus of cash and have been conducting buybacks very often. Also, Reliance Industries Ltd has surplus cash as well, however, this cash is seldom for buyback since the company has massive investments to make in sectors it operates in.
Read More: 10 Most Expensive Stocks In India
The advantage of the share buyback is more pronounced after the government, in Union Budget 2016, announced a tax on the hands of the investors if the annual dividend increases over Rs 10 Lakh.
So, the dividend is technically taxed at three stages – one is post-tax appropriation, second is dividend distribution tax (DDT) and last is 10 % tax on shareholders receiving the dividend.
Thus, the buyback of shares become more attractive, even after considering the 10% long-term capital gain (LTCG) tax.
3.Buyback Helps Improve Valuation
When a company buys back shares, the corporate action results in reducing the number of outstanding shares and the capital base. At the same time, this leads to an improvement in EPS and the ROE of the company.
Now when EPS climbs and assuming P/E remains constant, the price of the stock goes up. But this doesn’t happen always, and the P/E tends to go down, thereby neutralizing the impact on valuation.
Read More: What Is Margin Trading? Should You Use It?
4.To Signal That The Stock Is Undervalued
This is one of the main signals the company tends to send out by offering share buyback. The fact that the company uses its reserves to buy back shares from investors gives a hint to investors that the management perceives of the stock to be undervalued.
This act is more prevalent in cases where the stocks have corrected sharply despite no flaws in the fundamentals.
Shareholder’s activism has not been very prominent in India, but due to governance practices being implemented in the nation, the importance is increasing over time.
Companies tend to diversify in unrelated areas just because they are blessed with high cash flow. Instead of doing this, what makes more sense is to return the money to shareholders and let them decide on what to do with the surplus money.
6.Help Promoters Consolidate Their Stake In The Company
Often there are times when the promoters of a company are concerned with their holding in the company going below a certain level. Thus, the buyback helps consolidate the stake in the company. By offering buyback, the company tends to repurchase the shares from its existing shareholders.
Promoters, who are also shareholders in the company, if participating in the buyback, manage to maintain their stake in the company.
In case, the promoters do not tender their shares, and other shareholders provide their share for the cash offer, the stake of the promoters tends to increase. The increase is due to the reducing number of outstanding shares (denominator).
Conclusion: What Should You Do If A Buyback Is Offered?
The company goes for buyback only if they do not see any other alternative to deploy the excess cash generated. This, in a way, could also mean that the companies offering buyback could be lacking growth.
If you recall, IBM is one company that paid high dividends and also used to buy shares worth billions every year to deploy the excess cash generated. In India also, such a step is taken by many IT companies.
While buyback results in rising ownership but for the retail investor, this ownership percentage may not make sense owing to the fraction he/she may own.
Thus, you should consider not remaining invested for a very long term in such companies, and tender your share for a buyback.
Disclaimer: The views expressed in this post are that of the author and not those of Groww