Some few months back Coal India Ltd. (CIL), the near-monopoly coal producer
announced that it will seek shareholder approval at its upcoming Annual General
Meeting to amend its Articles of Association in order to facilitate buyback as it was sitting on cash pile of around Rs. 58,202 Cr as on March 2012. As
soon as this news was out, stock prices of CIL rose by more than 2%. The
reason for this price rise was primarily the expectation that the company will
announce a share buyback.
Historically,
share buybacks or even company announcements of a share buyback have had a
similar effect on the respective stock prices. The market is usually quick to
react positively to such news. But are share buybacks always beneficial to
investors? Before we answer this, let’s understand what is a share buyback.
What is a Share Buyback ?
The repurchase of outstanding shares by a company in order to reduce the number of shares on the market either to increase the value of shares still available or reducing the supply. There are
four basic options available to a company when it makes a profit: sit on the
cash, re-invest it into profitable opportunities, pay a dividend or buyback
shares.
Buyback
is generally seen as a method of rewarding shareholders by returning excess
cash to them, when a company doesn't see good growth avenues to deploy its
resources. This can be done in two ways:
- It can
tender an offer to existing stockholders to buy up to a certain number of
shares at a fixed price within a fixed period of time, or,
- It could
offer to buy the shares in the open market over a period.
What are the main intentions behind a Share Buyback?
There are
different motives that prompt the management to go in for a buyback of shares:
1.
To reward shareholders: When a cash-rich company doesn't see good
growth avenues to deploy its resources, it can choose to return cash to its
shareholders via buyback of shares. Such an action can be viewed positively by
the analyst community and reflect positively on the management.
2. To send out a confidence signal to the market: When a company
announces a share buyback, investors see it as a positive sign in terms of the
management’s belief in the company’s future growth & earnings. This could
act as a confidence booster and leads to investor's buying into the company’s
shares leading to a price rise.
Take for
example, the Reliance Industries buyback scheme which was announced in February this
year. After a series of quarterly results which were below expectations, the
share price was languishing at INR 700. The share buyback announcement which
was just 2 days before announcement of its quarterly results, led to a 5 % jump
on the day of announcement. It was largely seen as an attempt to shore up the
market sentiment in order to prevent a further fall in share prices after the
announcement of another set of poor quarterly results.
3. To
improve Financial Ratios: A buyback gives a temporary boost to some of
the key financial ratios of the company that are based on the number of shares
and cash as an asset. Suppose a
company buys back 10 lakh shares at INR 15 per share for a total cash outlay of
INR 1.5 crores. Below are the components of the Return on Assets (ROA) and
Earnings per Share (EPS) calculations and how they change as a result of the
buyback.
In the this grid, following a buyback, the company’s cash holding reduces from INR 2
crores to INR 0.5 crore, and the total assets of the company (cash being an
asset) reduces from INR 5 crores to INR 3.5 crores. This
leads to an increase in its ROA (Earnings/Assets) from 4 % to 5.71 %, even though
earnings have not changed. A similar
effect can be seen in the EPS number (Earnings/Shares Outstanding), which
increases from INR 0.20 to INR 0.22.
4. To
prevent dilution of control: A buyback helps to absorb the excess shares,
which were caused due to dilution, may be due to the exercise of employee stock option programs or due to conversion of FCCBs or warrents. Thus, a buyback
reduces the total number of shares outstanding in the market and helps to increase
shareholders value.
5. To
prevent unfriendly takeovers: By undertaking a buyback, the company makes
it more difficult for a raider to take control by acquiring majority stake from
the open market.
Now when we have clearly known about the prime intentions behind the Share buybacks, but are these buybacks always an good idea or can it decrease shareholder value. ?
When are the Share Buybacks not good for Shareholders ?
1.
Buyback of overvalued shares: a company buying overvalued shares from the
market would lead to destroying shareholder value, and would be better off
paying that cash out as dividends, so that shareholders can invest it more
effectively.
2. To
boost earnings per share: contrary to popular wisdom, increasing EPS doesn't increase fundamental value of the shares. Though the EPS derived from
the P&L statements of the company may seem to rise, there is no net
increase in the cash EPS. Since companies have to spend cash to purchase the
shares, valuations are adjusted for reductions in both, cash and shares.. The
result is a cancelling out of any impact in the cash EPS, as now lower cash
earnings are divided between fewer shares to produce no net change in the
earnings per share.
3. Using
borrowed money to fund the buyback: Using debt to fund a buyback could have an
adverse effect on the credit rating of the company, since in effect the company
reduces its equity, increases its debt, with no net increase in cash to serve
as a cushion for the increased leverage.
So, are Share Buybacks really beneficial for Shareholders ?
Stock
buybacks can be great for shareholders if the company cannot utilise the excess
cash productively. As mentioned before, it could lead to a cash inflow for
shareholders as also lead to appreciation in share price. However, the price at
which the company buys back the shares should be right.
On the
other hand, you should be careful and assess the reasons for the buyback. You
must exercise a reasonable amount of caution in the following cases:
- Where a
stock grant to employees by way of employee stock options or a stock issuance
for merger & acquisition is offsetting the shares taken out of circulation,
thereby resulting in no net increase in share value.
- Where the
management aims to cover up weak ratios or improve the market price of the
shares by playing with investor sentiments.
The new norms for Share Buybacks :
Market
regulator SEBI on February
7th 2012 modified norms for share
buyback through the tender offer route under which companies will have to reserve 15 per cent of the offer for small
shareholders.
"15 per cent of the number of securities which the
company proposes to buy back (through tender offer)... shall be reserved for
small shareholders," the Securities and Exchange Board of India (Buyback
of Securities) (Amendment) Regulations 2012 said. Small shareholder refers to a
shareholder who holds shares not exceeding Rs. 2 lakh of a listed company. The
buyback process through the tender offer route can be completed within 41 days
of the board approval.
As per the guidelines, a company would have to publish
advertisement in newspapers within 2 days after securing board approval for the
buyback and after 5 days it has to file the offer document with the Sebi. The
offer for buyback shall remain open for 10 working days & within 7 days the
company would have to pay the buyback amount to the shareholders.
Before this amendment there were two ways by which a company
can come out with a buyback - open market and tender offer. While
in open market offer companies can buy back shares from shareholders without
knowing the buyer, under tender offer the company has to write to every
shareholder saying it is willing to buy back shares in proportion to the issue.
Under Section 77A(2) of the Companies Act, 1956, Buyback of Equity shares by a company shall be up to 25 % of the total paid- up Capital and the amount intended to use for buyback shall not exceed 25 % of total paid-up Capital and Free Reserve and requires the approval of members by way of Special Resolution.
- Promoters shall not participate in the buyback.
- As per the Act, the ratio of the Debt owed by the company should not be more than Twice the Share Capital & Free Reserves after Buyback.
- The Company will not be allowed to issue fresh equity shares within a period of 6 months after the completion of the Buyback except by way of Bonus issue or in the discharge of subsisting obligation such as conversions of warrants, stock option schemes, sweat equity or conversion of preference shares or debentures into equity.
- The company should confirm that there are no defaults subsisting in the repayment of deposits, redemption of debentures or preference shares or repayment of term loans to any financial institution or Banks.
Example of calculation of the Buy Back -
The Total number of Equity shares as on 31st March were 218,16,86,781 shares
Maximum Amount permissible for Buy-back i.e. 25 % of the Total paid up and free reserve of Rs. 2,551.26 Cr = Rs. 637.81 Cr.
Maximum Shares permissible for Buy-back i.e. equity bought back cannot exceed 25 % of 218,16,86,781 shares = 54,54,21,695 shares.
So, Company can buy back 54,54,21,695 shares & money to be used should not be more than Rs. 637.81 Cr.
