“XYZ company announces a buyback of its shares”. You must have seen or read this headline multiple times in the last couple of years. Especially by companies from the IT or technology industry. According to reports, in the financial year 2018, buyback offers worth Rs. 50,000 crores were made in the Indian markets.
Have you wondered what is share buyback and what are the technicalities involved with it? Or if you should give up your shares during buyback offers? Then read on and get all your queries resolved.
What is share buyback?
- Buyback of Shares – Meaning:
A share buyback is a process through which a listed company uses its money and repurchases its own shares from the market. It is the opposite of an IPO (Initial Public Offer). Stock repurchase is also seen as a way for the company to re-invest in itself. Once the stock buyback is complete, they are absorbed and cease to exist. There are two ways in which stock buyback can take place:
- Tender Offer: In this buyback channel, the company offers to buy back a certain number of stock at a quoted price. The buyback is done directly from the shareholders.
- Open Market: The open market buyback takes place through the secondary market (stock exchange). The resolution (special or board) needs to specify the maximum price for the buyback.
2. Buyback of Shares – Regulations:
SEBI has laid down the following guidelines for buyback of shares:
- It cannot be more than 25% of the total paid-up capital value and free reserves held by the company. It needs to be approved by the shareholders through a special resolution.
- If the buyback value does not exceed 10% of the total paid-up capital value and free reserves held by the company, it necessitates only a board resolution.
Why do companies offer stock buyback schemes?
1. Surplus cash but lack of investible projects
This is one of the primary reasons behind stock repurchase by companies. Idle cash reserves come with a cost. Matured businesses do not need to invest exorbitantly in research, development or other such aspects. Also, holding on to unused equity funding results in ownership dilution without any good reason. Hence, companies prefer to buy-back their own shares.
Buybacks usually happen at a premium as compared to the market price. Companies prefer this route to reward shareholders rather than paying our dividends due to the tax implications.
Dividends attract 15% DDT (Dividend Distribution Tax) for the companies as well as 10% tax in the hands of shareholders if the dividend income exceeds Rs. 10 Lakhs. Hence, earnings through buyback become more tax efficient for both the parties, even after considering the taxes applicable.
3. Enhanced valuations
Buybacks are associated with enhanced share valuations as a result of an improved PE multiple. Stock repurchase leads to a reduction in the number of outstanding shares and hence, capital base. This, in turn, improves the value of EPS (Earning per Share) as the same amount of dividend is now divided between lesser shareholders. The ROE (Return on Equity) also goes up as the cash assets on the Balance Sheets come down.
4. Signal to the market
Stock buybacks are also used to send indicators to the market. It signals that the company has great confidence in itself. Hence it is ready to repurchase its own shares (mostly at a premium) as it feels that the company is undervalued currently in the market. For instance, when the company management is highly optimistic about the future prospects but the stock price still reflects bearish sentiments based on past performance only.
In some cases, promoters can also use the buyback channel to tighten their hold on the company. This is especially true when the shareholding is highly diluted or is in the hands of individuals or investors who do not have the best interest of the company in mind.
How to evaluate stock buyback offers?
Now you know what is share buyback and the reasons why companies offer them. But the fundamental question remains – what should be your stance in case of buyback offers? Should you hold your stock or give them up? These pointers can help you take the final decision:
1. Offer Price and buyback quantum
Buybacks are lucrative only when they are offered at a significant premium amount. The offer price must be substantially above the current market price to make it worthwhile for the investor. Also, the quantum of the share repurchase amount should be substantial.
2. Look at the tax implications
Till recently, shareholders had to pay capital gains tax on their buyback earnings. However, with the introduction of buyback tax for listed companies, investors are now exempted from the same. Companies will now have to pay 20% buyback tax.
This move has been done as the Government observed that more companies were distributing their profits through the buyback channel rather than dividend as the latter attracted DDT (Dividend Distribution Tax).
Note: The buyback tax is not applicable to companies who had announced their buyback schemes prior to 5th July 2019.
3. Promoter Participation
Promoters cannot participate in the buyback process if it is being done through the open market. However, they are allowed in case of tender offer. In case of participation by the promoter, there is usually a positive movement for the stock price in the long-term.
Buyback can be rewarding for both parties (company as well as investors). As an investor, it is important for you to understand the implications of each buyback offer and decide wisely. You should keep an eye out for the upcoming buyback of shares in 2019 and corporate news around the same. In case you feel that you are not able to decide on your own, you can always reach out to an expert like IndiaNivesh.
Indiaivesh has been providing excellent financial solutions to investors since the last 11 years. It offers a wide range of products – broking, distribution, equities, strategic investments, investment banking as well as wealth management. With its “client-first” approach, skilled and experienced team members and state-of-the-art research and technological capabilities, you can be rest assured that your financial interests are in safe hands.
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