Introduction to Buyback of shares

Content:

1. Introduction to buyback of shares
   1. Buyback Meaning
   2. Buyback Definition
   3. History of Buyback of Shares
   4. Buyback Eligibility Criteria for Companies
2. Buyback Reasons
3. Buyback Benefits and Drawbacks
   1. Buyback Advantages for the organization and promoters
   2. Buyback Advantages for Shareholders
   3. Buyback Disadvantages for the organization and promoters
   4. Buyback Disadvantages for Shareholders
4. Buyback Examples and Case Studies
   1. Buyback strengthens promoter holding
   2. Effective Utilization of Surplus Cash
   3. Buyback Improves Earnings per Share (EPS)
   4. Buyback thwarts a takeover bid
   5. Buyback Improves Debt Equity Ratio
   6. Buyback provides an easy exit route at an incentivized price to shareholders
   7. Possibility to overlook lucrative investment opportunities over gaining controlling stakes
   8. Judgement Error in Valuation
5. Key Takeaways
6. Buyback FAQs
7. Buyback Glossary

This chapter offers a basic introduction to the buyback of shares. It explains the buyback meaning, the history of buyback, reasons for which companies buy back shares, its benefits, and disadvantages. This chapter will help you make informed decisions by understanding the share buybacks concepts.

Meaning of Buyback of shares in the share market

A stock buyback means that a company wants to repurchase its shares from the existing shareholders who hold the shares. The process through which they do this is called buyback or buyback of shares.

The company's intention of a buyback offer is to reward the shareholders, restructure the capital structure of the firm, prevent hostile takeovers, or utilize its reserves in an efficient way.

Buyback in the share market is when a company buys back the shares that they have sold earlier. Usually, a buyback happens at a price slightly higher than the market price of the shares.

Buyback of shares definition

The shares buyback is a corporate event wherein a company offers to buy back the shares it had issued earlier to the market. This includes the associated process in compliance with the laws of the land which are mainly financial in nature.

The buyback definition has 3 important parts:

1. The company must have issued shares to the market earlier to be able to buy back shares.
2. Buyback is a corporate event that has an associated process.
3. The process must follow the legal norms of the land or country in which the buyback of shares is being executed.

Note:

• Buyback requires companies to follow a process set by SEBI, the market regulator and the Companies Act. These bodies define:
  1. Who can buy back shares?
  2. What are the buyback reasons?
  3. A buyback could be done how long after the issuance of shares?
  4. For how long the buyback issue remains open for public?
• There are two popular ways in which a company can buy back shares; Open Markets and Tender. Companies can also do buybacks through odd lots but it is not a common practice.
• A company could buy back shares worth 25% of the paid-up equity capital and the free reserves of the company.
• Unlisted companies can also do a buyback of shares depending on the class of shares that were issued.
• Fully paid-up shares alone are qualified for a buyback. These could be equity shares, preference shares, ESOPs, or Institutional shares. A company cannot buy back partly paid shares.

History of Buyback of Shares

The Companies Act, of 1956 had provisions in Sections 77A, 77AA, and 77B for buyback however a company was prohibited to buy back its own shares. The only exception was the need for a reduction of share capital.

With changing situations around the world, the Government of India realized the importance and need for the buyback. In 1998, SEBI framed the SEBI (Buy Back of Securities) Regulations. At the same time, the Department of Company Affairs also worked out the Private Limited Company and Unlisted Public Company (Buy Back of Securities) based on Section 77A of the Companies Act.

In order to prevent fraud or malpractice of any kind, SEBI also incorporated strict guidelines that cannot be violated pertaining to the announcement of the buyback of shares. This ensures that both companies and shareholders experience share buyback benefits. This is buyback history in India.

Eligibility Criteria for Companies for buyback of shares

A company wanting to buy back the shares is required to meet the following criteria to be eligible to think about buyback of shares:

• The company should be a listed company on a stock exchange in India.
• It should have sold its shares while listing through an IPO in compliance with the norms in India.
• The company had sold its shares more than 6 months before.
• The company directors have agreed to buy back shares in a special meeting held to buy back shares.
• The company complies with the buyback norms of the Companies Act 1956, 1999 as well as the norms laid down by SEBI.
• The company should have not defaulted in a period of 3 years on shares, debentures, interests, and dividends.

---

Buyback Reasons

A company opts for buyback for any one or a combination of the following reasons.

1. To increase promoters holding

   The buyback of shares helps to increase promoter holding in the company. A company with a higher promoter stake is generally considered safe for investment. This also signals that the promoter is sure of the business model and the profits.

   After a buyback, the shares bought back are submitted to the treasury or completely nullified. As a result, the total number of shares of the company gets reduced. But the total number of shares owned by the promoter remains the same thereby increasing their stake.

2. To use surplus cash

   Many times, a company is left with surplus cash after they have executed existing expansion and growth plans, dividend distribution, bonuses distribution to employees, etc. This money left idle will not add any value to the company. In such a situation, the organization may choose to do a buyback of shares and reward the shareholders. It incentivizes the shareholders who trusted the company by investing in them.

3. To rectify the market value of undervalued stocks

   When the management of the companies feels that their stocks are undervalued in the market, they can opt to go for the buyback. The goal is to improve the valuation of their stock. The total number of stocks gets reduced upon buyback. This reduces the supply of stock giving a price boost to the shares. Secondly, the company buys back the shares at a higher price than the market value. This automatically increases the share prices.

4. To improve financial ratios like Earnings Per Share (EPS), Return on Equity (RoE), Return on Capital Employed (RoCE)

   Sometimes, a company may be planning an expansion in the upcoming year. For this, they may

   need investments. One of the criteria investors may look for is the company's EPS and return on capital employed. In such a situation, a company can buy back its shares without changing any other existing business and improve these financial ratios by reducing the equity base.

5. To block a hostile take-over bid

   The buyback also acts as a defense strategy to prevent a hostile takeover by any company. The buyback results in increased promoter holding and a reduction in shareholder stakes. This prevents the acquirer company from executing their takeover plans as a major part of the holdings would be the promoter and thus approaching shareholders for a takeover would be of no use.

6. To improve the Debt-Equity Ratio

   The debt-equity ratio represents the capital structure of a company which tells about the sources of funding for the company. The ideal debt-equity mix for each company is different. When a company feels it has more Equity, which is an expensive mode of capital over debt, the company can buy back its share to balance the debt Equity ratio and thereby reduce its cost of capital.

---

Buyback Benefits and Drawbacks

A share buyback has its pros and cons that impact both the company as well as the shareholders. Let us have a look at these advantages and disadvantages in detail to understand them better.

A share buyback is beneficial for the company as well as the shareholders in the following ways.

1. Buyback Advantages for the organization and promoters

1. Boosts the price of undervalued stocks

   The buyback of shares helps to increase the share prices and thus provide a better valuation to the company and maintain the confidence of the shareholders.

2. Improves the company's financial optics like EPS, ROE, ROA

   The buyback of shares leads to a reduction in the overall number of shares/share capital as the shares bought back get extinguished. The same earnings now get distributed among a lower number of shares or assets. This improves the EPS, ROE, and ROA for the company without making any operational or business changes.

3. Optimizes the capital structure of the company

   A buyback helps to restructure the capital mix of the company when a company's leverage on Equity is more than required compared to Debt.

4. An alternative way to legally reduce capital without approvals from NCLT

   Any scheme of capital reduction requires approval from the National Company Law Tribunal (NCLT) except for buyback wherein the company management can decide on the buyback in the board meeting.

5. Works as a Defence strategy against hostile takeovers

   A buyback helps to protect the company from any hostile takeover by increasing the promoter's stake.

6. Optimum cash utilization in the absence of better investment options

   An important aspect of any organization's existence is the optimal utilization of its free reserves. Buyback can help to deploy the idle cash to better use and reward the shareholders for their trust in the company.

7. Reduces the cost of capital

   Buyback reduces the equity capital of a firm by buying back equity shares from the shareholders. This helps to reduce the overall cost of capital by cutting the cost of equity in the form of dividends, bonuses, etc that was required to maintain that capital.

8. Serves as a health check for the company

   A company announces a buyback only when it has free reserves. This represents the healthy financial status of a company giving a positive signal amongst the shareholders.

2. Buyback Advantages for Shareholders

1. Provides an easy exit route from undervalued shares

   A company does a buyback at a price that is higher than the market price. If the shares have not been doing well, the shareholder may seek to get the maximum price possible and exit the shares.

2. Provides an incentivized price for shares compared to market rates

   Since a company buys back shares at higher then the market price, the shareholders get an incentive to sell part or whole of their shares at higher than market prices.

3. Exempt from Capital Gains Tax

   A shareholder who participates in a buyback (announced post 5 July 2019) of a publicly listed company does not have to pay any Capital Gains Tax on the income arising from the tendered shares in buyback.

4. Option to participate or ignore the offer

   Buybacks are not compulsory. A shareholder can either choose to sell the entire shares or a part of shares and enjoy the quick gains or can choose not to participate in the offer and hold the shares if the shareholder has studied the financials and is assessed to make handsome profits in the long run.

3. Buyback Disadvantages for the organization and promoters

1. Improvement in financial ratios may not be real

   The changes in the financial ratios may be a short-term reflection and not connected to the overall business performance.

   This can be misleading financial ratios for the investor to make unbiased decisions. These ratios are not a true reflection of what the business can generate but only an adjustment basis reducing company assets.

2. Possibility to overlook lucrative investment opportunities over gaining controlling stakes

   The primary responsibility of a company is to maximize profit for its shareholders. Sometimes, companies may buy back shares without keeping aside funds for lucrative investment and growth opportunities.

4. Buyback Disadvantages for Shareholders

1. Possibility of shares not getting accepted in buyback

   An investor may buy shares once the buyback gets announced with the expectation to tender the shares in buyback and earn quick returns. However, with so many shareholders participating in buyback and limitations on the number of shares that can be bought back, it is possible that not all shares tendered by the shareholder would get accepted. This may incur a loss to investors if share prices drop post the buyback window.

2. Temporary price boost

   Many times, the price boost is for a temporary phase leading to a loss for investors if they intend to do short-term trading.

3. Judgment Error in Valuation

   This happens particularly when the promoter/s buyback shares because they know that the stock is undervalued. In such situations, the prices of shares go up, and the shareholders incur a notional loss. If the shareholder had not participated in the buyback and had held the shares, he/she would have earned more profits than he earned in the buyback.

4. Small acceptance Ratio

   Most Buybacks from popular companies have a small acceptance ratio, for example; 20% in retail and 2% in HNIs are accepted by the company.

   TCS buyback on March 5th, 2022, the company accepted 26% shares in its buyback in the retail category. People who applied for 50 shares got accepted 13 shares. The HNI acceptance ratio was 2.45%.

   The acceptance ratio in a buyback depends on many factors including buyback size, retail holding, price of shares just before the buyback closes etc.

---

Buyback Examples and Case Studies

1. Buyback strengthens promoter holding

Company ABC has:

• Total number of shares: 1,00,000 Shares
• Promoters Holding: 20,000 Shares (20%)
• Public Holding: 80,000 Shares (80%)

After Buyback:

• Buyback Shares: 30,000 Shares
• Total Shares left after buyback: 1,00,000 - 30,000 = 70,000 Shares
• Promoters Holding: 20,000 Shares (28.57%)
• Public Holding: 50,000 Shares (71.43%)

In the above example, the promoters holding increased from 20% to 28.57%.

2. Effective Utilization of Surplus Cash

Let us say that a pharmaceutical company XYZ made profits to the tune of 300%. Their planned expansions next year will take up 30% of the total profits generated. A dividend will take away another 30% of the profits. The company has explored further avenues of expansion or growth, but there are no other viable options. The company will still have a significant amount by way of 240% of surplus cash.

In such a situation company promoters buy back some of their shares from the market to reward shareholders, improve investor confidence, boost share prices, increase promoter stake and improve key financial ratios of the company.

3. Buyback Improves Earnings per Share (EPS)

Let us assume that company A has before buyback:

• Total Shares: 10,000 Shares
• Current price: Rs 16 per share
• Current Earning: Rs 2,500
• Current Earning per share (EPS): Rs 0.25 (Rs 2,500/10,000)

Let Say Company does a buyback of shares with additional cash they have:

• Number of shares to buy back: 1,000
• Buyback Price: Rs 20 per share
• Money spent on Buyback: Rs 20,000

After Buyback:

• Total Shares: 9,000
• Current earning (remain same): 2,500
• Earnings per share (EPS): Rs 028 (Rs 2,500/9,000)

After the buyback, the earnings remain the same but the shares and cash get reduced. This means that the same earnings now get distributed to fewer shareholders. This also means that the same earnings get spread over fewer assets. So, without doing any additional business, the company has automatically improved it's ROA (Return on Assets). The company has also improved its Earnings per share and P/E Ratio.

*Assumption: Share Price is assumed to increase post the announcement of buyback.

From the above table, we observe that:

1. The ROA increases from 4.55% to 6.25%.
2. We can also see an improvement in EPS and PE ratio that increases from 0.25 to 0.28 and 64 to 72 respectively.

Thus, these improvements reflect positive indicators and can be a useful tool for the company in its expansion plans.

4. Buyback thwarts a takeover bid

Let us take the example of company A and company B.

Company A is a much smaller company. It is working on making a technology patent that will increase its growth 4 times overnight.

Company B on the other hand is a large traditional business. It has 1 subsidiary that works in the same field as Company A. But it does not have any patentable technology that will help the same scale of growth.

Here is how the conversation between Company A and Company B will go:

• Company B: We would like to invest about Rs 50,000 in your company and get a 50% stake in your company.
• Company A: We are happy that you found us suitable for the offer, but at this point we are all focused on our technology patent and have enough funds to make it work out.
• Company B: Let me make the offer sweet by offering your promoters 2% equity in my company and another Rs 500 cash.
• Company A: We feel that the offer is too low since we already have clients for our technology which is still not launched. The total value that the clients are offering comes to at least Rs 4,00,000 and it will be difficult to match that offer.
• Company B: Yes, true, but the amount we are paying on your current valuation is at least 100% higher.
• Company A: It is a generous offer for us today. We agree, but we will be unable to take it up in the interest of the Rs 4,00,000 that we will get within just 6 months.

Now Company B is not likely to give up. The promoters of Company B go to the stock market and start buying the shares of Company A. In order to have a controlling voice on the board, the promoter of Company B needs to own at least 17% or more shares of Company A's total outstanding shares of 20,000.

So, Company B decides that it will buy 5000 shares of Company A's from the market. The market value of each share of Company A is Rs 1. Buying 5000 shares will cost Company B only Rs 5000.

• Day 1: The fund managers of Company B buy 500 shares at Rs 1. This results in the share price going up by 10%
• Day 2: Company B through its people buys another 500 shares at Rs 1.1. The share prices go up by another 20%.
• Day 3: Company B buys another 500 shares at Rs 1.32. The market is now alert to why the share prices are going up. This is especially since no new information or market movement or industry growth.

At this stage, Company B already owns 1500 shares. They now need to buy only another 3500. But Company A starts digging by midday of Day 3 and finds that it is people associated with Company B who are buying the shares. This gets the promoter of Company A worried because his own shares in the company are only 2000. He realizes that he needs to increase his shareholding. He now prepares to launch a buyback offer for just 5000 shares. This way, the promoter of Company A will have the controlling shares in his own company.

We see here that promoters sometimes need to buy back shares. This helps maintain control of the company. It helps them stop another person or company from taking over their business.

5. Buyback Improves Debt Equity Ratio

Let us consider a very simple example.

Company X had a Debt-to-Equity Ratio of 0.20. With buyback, the equity capital gets reduced and the Debt Equity Ratio increases to 0.29. A company uses buyback as a strategic tool to restructure the capital structure of the firm.

6. Buyback provides an easy exit route at an incentivized price to shareholders

Let us say that Company X has 1,00,000 shares that are now valued at Rs. 200 each. The company has recently acquired another company. This added 45% to the top line of the company and 15% to the bottom line. But the share prices go up only to Rs. 220.

The company still has a cash surplus of Rs. 50,00,000. In order to improve the prices, the company decides to buy back 20,000 shares at Rs. 250 each. This is Rs. 30 more than the market price and 13% higher than the current market price. This makes the share prices better valued. For a shareholder who was expecting the prices to go up to Rs. 240 per unit, this is an easy exit route.

The shareholder is getting a premium of Rs. 30 per unit compared to the market price. This is a significantly higher incentive for the shareholder. It would not have been available at that time through any other route of trading.

7. Possibility to overlook lucrative investment opportunities over gaining controlling stakes

Company D is a listed company in the pharma sector and has surplus cash of Rs. 35 crores this year. It has kept aside contingency funds, and given dividends and bonuses as well.

Now, it has 2 options:

1. It can acquire a new company YY working in RH drugs for Rs. 10 crores or
2. It can utilize Rs. 10 crores for improving the promoters controlling stakes.

Company D announces a buyback of each share at a 30% premium. The next year, however, company YY announced profitability (PAT) of Rs. 20 crores. In contrast, the share price of Company D has grown only by 10%. This increases its total equity to just Rs. 18 crores from Rs. 15 crores.

Company D lost a lucrative investment opportunity and took the wrong decision to increase its controlling stake over acquiring a new and profitable line of business.

Another example that depicts that buybacks can go wrong if Companies do not keep enough cash surplus for their survival in dire situations. In 2019 Company FF, a listed real estate company decided that this year on account of 2200 crore profit, they will buy back 25% of the paid capital shares. (This is the maximum allowed by SEBI). This will improve their holdings significantly but will reduce their total assets by 40% and cash surplus by 100%. Subsequently, they invest the balance surplus into inorganic expansion. In 2020, the Covid Pandemic hits the world and business come to a standstill. Company FF, which has 11 projects running cannot pay for the material requirement nor for the labour because it has no surplus cash available.

They have to relieve 50% of their staff and the speed of work goes down. This leads to a higher-than-normal delay in project delivery, a 50% reduction in sell-through rate, and thus a 50% reduction in collections as well.

Company FF is not able to survive and has to raise funds through borrowing or investors or dilute the promoter share.

8. Judgement Error in Valuation

Let's say that listed pharma company AGA announced a share buyback on 30 December 2021. In the announcement, the company has announced that of the total of 30,00,000 shares, it will buyback only 1,00,000 shares at 50% above the market price. There are a total of 50,000 shareholders owning these shares.

Shareholder B knows that the company is going to announce its cancer-resistant drug next

year. Shareholder B owns 70,000 shares. Then Shareholder B can tender to sell only 10,000 shares from 70,000 shares to encash the profit. Shareholder B can wait for the announcement to be able to make a higher profit the following year.