Buy Back – A Bumper Offer???

Last Updated on March 4, 2020

I am sure most of us must have heard of those attractive cash back offers from some credit card schemes while we go on a shopping spree & got lured by such offers? Ever heard of such an offer while you are out on a stocks shopping spree?  Does a buyback offer of shares somewhere sound the same?

The latest buzz these days is the open offer of Satyam Shares. Hearing so much about it, I really wanted to know why various companies go in for a buyback.  In Satyam ‘s case it is very clear, Tech Mahindra is buying the stake from the public through an open offer.  Another obvious reason is to increase the promoter’s stake in the company.

Buyback is basically the reverse of issue of shares by a company where it offers to take back its shares by the investors at a specified price.

But what about the other companies? What are the reasons they carry out a buyback?

1) Surplus Funds: When a company has huge cash reserves/surplus funds but does not have any suitable investment opportunity/project to put that money into. Though it is the main objective of companies to maximize profits, there are situations when a company may not find any appropriate investment strategy. In such a case it opts for a buy back.

The debt of a company going in for a buyback due to excess cash reserves should not be high. A company usually under heavy debt are unlikely to have free cash.

2) Takeover: In this case the acquiring company buys the shares of the acquired company from the public at a certain fixed price. For eg: Satyam’s open offer carried out by Tech Mahindra @ Rs.58. (The irony here is that as of date Satyam’s share price is much higher than the price being offered).

A similar kind of buy back was carried out in the case of Cadbury India by UK-based Cadbury Schweppes Plc and Cadbury Schweppes Mauritius.

3) Surpassing the Tax Burden: There are 2 ways in which a company can benefit the investor.

1) By distributing dividends 2) When the investor gets a capital appreciation once the share price increases.

In the case of dividends, the company has to bear the burden of tax while distributing dividends.

In a buyback offer the share price of a company usually appreciates. Hence the company prefers rewarding the investor in this way.

4) Market Perception & Investor Confidence: By buying the shares at a price higher than the prevailing market price the company signals that its share valuation should be higher. For example: Reliance Energy came up with its buyback offer at R.1600 at a premium of 9.6% to its share price in order to gain investor confidence in the share. Companies also come up with a buyback offer to reduce the volatility in the share trying to actually prove that the stock is actually worth a certain price.

The above points are quite on the positive side. There are few other reasons why companies go in for a buyback:

1) Show Rosier Financials: There is a slight possibility that companies can use the buyback method to show better financial ratios. When a company buys its own stock using the cash reserves it reduces its outstanding equity hence increasing the Return on Equity. And since the number of outstanding shares reduces the EPS rises & the PE shows a better picture.

2) Avoid Scrutiny of Accounts & any Legal Control: One can get a little suspicious when a company buys back 100% of its shares from the market.  A company wanting to escape monitoring of its books of accounts or any other kind of legal control/scrutiny leading to delisting can take to this option.

The main plus point of buy backs are:

Investors gain confidence in the share for two reasons:

a) Companies that buyback the share at a higher price than the current trading price in a way are showing that the company is worth much more than its current price.

b) It also shows that the concerned company’s financials are quite sound since it has enough cash to buyback its own shares.

It is infact said that buy backs is one of the best strategies to maintain the share price in the bear run, by buying back the shares from the open market at a premium over the prevailing market price.

Conclusion:

A buy back will usually increase a company’s share price, but analyzing the reason for the buy back & ultimately believing in the fundamentals of the company is important.

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