- Wealth PMS (50L+)
Companies are allowed to buy their shares back in certain circumstances. But buy-backs in public markets have a number of nuances that lay investors may not be aware of. Additionally, an announcement of a buyback offer doesn’t necessarily mean much; it is quite as likely to be a head-fake to just push the price of the share up, rather than a real intention to benefit investors. But first, let’s cut to the what-the-heck.
Companies that are listed have their outstanding shares available for sale on the stock exchanges. In most cases, a company cannot hold its own stock (other than rare cases, when a company mergers with another company or such). The number of shares outstanding give you the ‘bang for the buck’ in your share, since profits are theoretically distributed to every share equally. The earning per share, a key valuation metric for your purchase or sale, will grow as profits grow, but only if the total number of outstanding shares remains constant.
A company can issue new shares in a number of ways:
Some of these methods happen constantly – like stock options or convertible debentures. So your profit per share will keep getting eroded if new shares keep getting issued.
A company in India can’t just go sell its own shares in the stock market directly. Any fresh issue of shares is regulated, and requires disclosure (so you know how much you’re getting diluted).
While shares only keep getting added, there is only one way for shares to be removed – a company buyback. If the company takes back whatever shares it issued, and extinguishes them, the total number of “outstanding” shares reduces.
Two methods. One, a company provides a tender offer to buy back shares. All shareholders will receive an offer for the buyback including the price, and can tender their shares accordingly. However as the company may not want to buy back all outstanding shares, only a percentage of shares may be accepted – the rest will be returned to your demat account. The acceptance is proportionate – so they take all the shares submitted, and then accept everyone’s shares in the ratio of (total number of shares to be bought back) : (submitted shares).
The other method is a market buyback. The company could decide to buy shares directly from the market instead of a buy back offer. The flexibility here is that the company need not fix a price – it can fix a ceiling price only below which it will buy shares. When shareholders approve, they provide management with how much can be spent to buy shares back, but there is no lower limit. Company management will appoint a banker to buy shares back, and as long as the shares are below the ceiling price the banker is supposed to buy shares, with instructions from management.
Tender offers are straightforward. The offer is at a fixed price, and open for about a month or so. At the end, the company reveals how much it can buyback, and returns the excess if any. That’s pretty much it.
Market buybacks are more complex. Since the price will vary every day, and the promoters have control over how much is bought at what price, the disclosure norms are hiked to ensure that investors know what’s happened.
Currently, listed companies are required to announce to stock exchanges their daily summary of shares purchased, and to publish the buyback status in a fortnightly release in a national newspaper. Additionally, companies cannot issue new shares during a buyback or six months after, including raising of fresh capital, conversion of warrants, grant of shares to employees having ESOPs (in the process of vesting), or even a bonus issue.
Further, during the buyback period, management is not allowed to trade in the security as they have the use of company funds to manipulate the market. But let’s stop laughing because we all know how effective that rule is likely to be.
While there are no tax implications to market buybacks, a tender offer buyback has the downside that you have to pay capital gains tax on any profits. This is 10% or 20% of gains (the former if gains are not indexed to inflation). Thus a tender offer of Rs. 600 in the market for a share bought at, say, Rs. 300, could be just the same as selling it in the market at Rs. 570 (since market sales don’t attract any capital gains tax currently). Which is also why tender offers are at a premium to the market price; to offset tax payments.
Updated Jan 2022: The tax treatment on buybacks has changed. Now, if a share is bought in a buyback, the company pays 20% tax on the amount paid. The shareholder pays no tax on capital gains on the buyback. Buybacks in a tender offer are simple – you pay zero tax on the gains on the shares that you tender which are accepted. For a market buyback, the company buys back the share in the open market. So, if you have sold shares and by some chance, the company is on the buying side of that trade (known only later, when trades are matched) you will get a mail from the exchange saying that you’ve had a buyback trade. For such trades there is no capital gains tax.
Buybacks have their problems. With the inability to raise further capital for 6 months, and even to convert old promises like existing convertible debentures, the tool is not very acceptable to companies in sectors where capital requirements can be intensive.
Further, many promoters use announcements to rig the price. They announce that a buyback will be done at a price, for this many shares. People then get excited and go buy the stock. But no buying comes through, and the offer ends. This is a loophole that the company is not required to buy.
And then, companies issue buybacks even when they have large amounts of debt. Case in point: Deccan Chronicle, the ex-owner of the Deccan Chargers IPL team, which defaulted on debt in June 2012, ran a 240 cr. buyback offer (market buyback) in 2011. This has now been addressed, as SEBI will not allow buybacks in companies that have more than 2:1 debt to equity after the buyback.
In other cases, companies have bought back shares just to issue them back as stock options. This is not a good precedent. (See: Crisil did exactly this)
SEBI has a new paper out on how to tighten regulation here, including:
These are interesting changes, but nowhere near enough.
Share buybacks are useful though many restrictions still prevent it from being an attractive concept in India. There are likely to be more buybacks in a down year, though, as promoters feel that’s the best way to use the stash.
Oh, and also read, “Buying back our deficit“.