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Concepts & Tutorials

Demystifying: Share Buybacks

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.

What The Heck Is A Buyback?

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:

  • An IPO or FPO with bids invited from everyone.
  • A private placement to a promoter or an institution
  • A convertible debenture (debt convertible to equity)
  • Issue of stock options to employees
  • An acquisition where the company issues fresh stock to the acquired company

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.

Why would a company buy shares back?.

  • To return surplus cash that it thinks can’t be easily used in the near future. This could be achieved by dividends, but dividends have a distribution tax in India, and foreign shareholders must additionally pay their own country’s taxes on the money. A buyback will achieve a return of cash by increasing the earning per share since there will be lesser shares outstanding.
  • To offset the issue of new shares through options or such. Practically, this is the reason though never stated. It is offensive, because instead of issuing share options while buying back shares, the company might as well pay the cash to the employee, which would be a more accurate reflection of compensation. However companies like to use the stock option route because of the lower taxation it involves and the fact that the compensation has an upside built into a growing stock price.
  • To support the stock price. When a company has a lot of cash and the stock price doesn’t adequately reflect value, management could apply the cash to a buyback and thus attempt to provide a floor for the price. I’ll stop here so you can laugh your head off, since you know that this is enough grey area for the word "manipulation" to make an entry.

How do they buy shares back?

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.

Disclosure, Regulation and Transparency of Market Buybacks

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.

Problems

Buybacks have their problems. With the inability to raise further capital for two years, 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.

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 Paper on Reforms

SEBI has a new paper out on how to tighten regulation here, including:

  • Ensuring that buybacks do at least 50% of what they are supposed to do – i.e. buy back shares.
  • Reducing the time for market buybacks from 1 year to 3 months. Companies must put 25% of the amount into escrow.
  • Companies can’t raise further capital for a period of 2 years after the buyback.
  • If the company doesn’t buy back 100% of what it expected to buy, the company won’t get to do another buyback for a year.
  • More details in the disclosure document, which needs to now be produced monthly.
  • All buybacks of 15% of capital+reserves will go through the tender offer route (currently it’s managment rule here)
  • ESOPs to be allowed during buy backs (that is, there can be conversion of an ESOP to shares) proveded that management or directors aren’t  given these shares.

These are interesting changes, but nowhere near enough.

Conclusion

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".

  • Bhaskar says:

    Thanks Deepak for this post.
    Wish you a very very happy and prosperous new year.
    1) Marg could be a good case study for buybacks 😛
    2) Could you please do a similar article on pledged shares. What prevents an institution which holds pledged shares to short the same stocks (from their trading desk), thereby resulting in margin calls and then dump (sell) some part of the pledged shares thereby resulting in massive stock price downfall.
    3) Have you looked at Zylog Systems both technically and fundamentally. I was getting the itch to get in at 60-70 levels but trying to be greedy and would wait till 30 levels. A bit of research shows the company does have genuine products, employees .. Rumor was employees were not paid their salary recently.
    4)Tulip Telecom was another case which i missed sadly. Seems they have a huge data centre in Bangalore (India’s largest ?)
    (btw welcome back to Bangalore, i am a silent reader of your blog and like your posts)

  • S Rangan says:

    Chemplast Sanmar announced a buyback last year, at Rs.4.9x or so per share. Eventually, the shareholders (?) bargained for more and bid it up to Rs.15 per share. What exactly happened there?