Posted in Finance Articles, Total Reads: 1418
, Published on 25 December 2014
Relatively new practice in India:
Investors need to understand the system of share buyback. This is a relatively a new practice in India. It was introduced in India in October 1998.
It may be mentioned in passing that the U.S was the first country to have the practice of share buybacks as early as in 1970s. Thus, the idea of share buyback originated in the U.S. and later on spread to other countries. The U.S. companies can be regarded as having innovated this corporate practice.
The basic idea:
Share buyback refers to a listed company buying its own share from the existing shareholders up to a defined quantity within a defined price limit. A company is not allowed to buy back its shares so as to delist the shares from the stock exchange. The central idea behind share buyback is to boost the return on equity by using surplus cash which is truly surplus in the sense that it is not required by the company in the foreseeable future.
What led the Indian government to allow share buyback?
The immediate reason which prompted the Indian government around 1996 to consider the introduction of the share buyback system was the prolonged depression in the stock market. Share buyback system was expected to remedy this problem. The government of India decided to implement the share buyback system on urgent basis through an ordinance promulgated on 31st October 1998. Later on, the companies (Amendment) Act 1999 was enacted and was deemed to have come into force from the date of the ordinance.
How share buybacks can help:
There are several reasons why a company may decide to buy back its own shares. They are briefly indicated below:
• Firstly, as already mentioned above, the company has surplus cash which is not required by it in the foreseeable future. If such surplus cash is returned to the shareholders, it would benefit the company as well as its shareholders. It will also be good for the economy in general by promoting better use of the country’s capital resources. Continuing to hold surplus cash pulls down the rate of return earned by the company on the total assets. This would ultimately affect the shareholder value adversely. Share buyback would enable the shareholders to invest this money in a more profitable way.
• Of course, surplus cash, if represented by profits earned, can also be returned to shareholders by distributing a higher dividend. However, this would mean highly fluctuating dividends, creating uncertainty in the minds of investors. Hence well managed companies attempt to pay steady and rising dividend rather than fluctuating dividends.
• Further, a company can enhance the earnings per share through buyback of shares. A company’s total earnings can be expected to be maintained if the share buyback is out of surplus cash, which is truly surplus. Moreover, share buyback will reduce the total number of shares, thereby increasing the per share earnings.
• Still another argument in favour of share buyback system is that the shares of many small and medium sized companies are not tradable or they can be traded only at heavy discounts. Share buyback system can provide a better exit route to shareholders in such cases as it would enable them to realize a better price.
• Share buybacks can be helpful in conveying to investors that the market is currently undervaluing the company’s shares and that the proposed share buyback would facilitate recognition of the true value of the shares.
The promoters’ view point:
From the promoters’ point of view, share buybacks enable the promoters to increase their relative voting power without having to invest their own money. Share buyback is out of the company’s funds. Legally, the promoters are not prohibited from offering their shares for buyback but they usually do not offer their shares for buyback by the company. If promoters intend to offer their shares for buyback by the company, this has to be disclosed.
Empirical findings on effect of share buyback:
Empirical data supports the generally favourable effects of share buybacks from the shareholders’ view point. A comparison of a sample of companies which had resorted to share buyback with non-buyback companies had shown that a significantly greater proportion of buyback companies had increased their EPS after the buyback compared to non-buyback companies.
A company’s dividend per share is usually expected to increase after the company buys back some of its shares. This is because the total number of shares is reduced after buyback but the profits available for distribution are unlikely to be affected by share buyback. In fact, it has been found that the EPS in most cases increases due to share buyback. Some step up in dividend may be expected when a company’s EPS has gone up. Of course, changes in dividend are a matter of deliberate policy and are usually made with a time lag.
Share buyback can be regarded as a minor kind of financial engineering which generally has a favourable effect in the immediate future on the share price, the EPS and the dividend. This findings is supported by the theory behind share buyback. Of course, the fortunes of a company are affected by a great variety of factors, especially over long periods.
Methods of share buyback:
A share buyback offer may be either:
a) Tender offer or
b) Open Market offer.
In the case of tender offer, the company commits itself to buyback a definite number of shares from the existing holders on a proportionate basis. Tender offers may be fixed-price buyback offers or they may be auction-based offers, using a reverse book-building procedure. In the normal book-building procedure used for allotting new issues, the book-building starts from the highest bidders and stops at the cut-off point at which the shares to be allotted are all exhausted. On the other hand, the reverse book-building starts with the lowest bidders and stops when the quota of shares to be bought back is exhausted. This minimizes the buy-back cost. It may be mentioned in passing that the regulations prohibit share buyback from any person through negotiated deals.
Open market offers:
Under the share buyback regulations in India, a company going for open market method has to announce the “maximum price” limit for repurchase of its shares without committing to buy any definite number of shares at any price within the price limit. Hence, at what price, on which days and in what quantity the company will repurchase its shares are all at the discretion of the company’s management. How the discretion will be exercised and the considerations guiding the management are, in practice, not disclosed to the public.
More transparency needed:
It may be noted in this context that in the case of open market offers in India, there is no transparency in the buyback procedure. In several instances of open market offers, the companies did not buyback a single share even though the market price of the shares had fallen much below the maximum authorized price for the buyback. In certain cases, the authorized amount for buyback was too low.
Disclosure of only the maximum authorized price is of no use to shareholders. What is required from shareholders’ point of view is disclosure of the “Minimum support price”.
This article has been authored by P.Mounika from Emeralds School of Business
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