In the last 2 years we have seen a number of companies, especially companies from the technology sector, announcing buyback of shares. Before we get into the nuances of buybacks in India let us understand how the global scenario on buybacks operate. Globally, there are two ways that a company can buy back its own shares. Firstly, it is possible to buy back the shares and hold these shares as treasury stock in the balance sheet of the company. This is used by the company for treasury operations. Secondly, you can buy back the shares and extinguish the shares, thus reducing the outstanding shares to that extent. In India, the first method is not allowed and shares can only be bought back for extinguishing.
So, why does a company buy back shares? What are the reasons for buyback of shares? One needs to understand the benefits for the shareholders and for the company in question. The key question is about the share buyback benefits for shareholders.
1. Lots of cash but few projects to invest in
This is one of the primary considerations for companies to buy back shares. Typically, Indian IT companies like Infosys, TCS, Wipro and HCL Tech were sitting on billions of dollars in cash. Now, cash in the bank has a cost and it is better returned to shareholders. A company like Reliance Industries may have billions of dollars in cash but it also has massive investments in the field of telecom. Most of the IT companies are operating on matured business models and there is not much to invest in terms of new projects. Too much cash in the books and too few investment opportunities is a key reason for buyback of shares.
2. Buybacks are a more tax-effective means of rewarding shareholders
This advantage became pronounced in India after the Union Budget 2016 when the government announced the 10% tax in the hands of shareholders if the annual dividend exceeded Rs.1 million. Now, dividends paid by companies are being virtually taxed at 3 levels. Firstly, dividends are a post tax appropriation, and then there is dividend distribution tax (DDT) of 15% when the company pays out the dividend and finally there is the 10% tax on shareholders. The 10% tax actually hit promoters and large shareholders the most. In comparison, buybacks are attractive in tax terms even after considering the 10% tax on LTCG that was imposed in the 2018 budget.
3. Theoretically buybacks tend to improve valuations of companies
When a company buys back shares, it results in a reduction of the number of shares outstanding and the capital base. To that extent, it improves the EPS and the ROE of the company. When the EPS goes up, assuming the P/E remains constant the price of the stock should also go up. However, in practice it does not normally happen. When a company buys back shares it is seen as a business with very limited future investment and growth opportunities. Hence, such companies tend to quote at lower P/E ratios since P/Es are normally driven by growth. So, while the EPS goes up the lower P/E tends to neutralize the impact on valuation.
4. Company can signal that the stock is undervalued
This is perhaps the main signals that companies like to send out by buying back shares of the company. The fact that the company has confidence to use its reserves to buy back its own shares give a hint that the company management perceives it as undervalued. This is more relevant in the case of stocks that have corrected sharply despite no apparent fundamental flaws. Under these circumstances, it could be a good idea for the company to buy back the shares and signal the bottoming of prices. While the stock may not appreciate sharply, it helps the stock find a bottom in most cases.
5. Returns cash to the shareholders of the company
In India, shareholder activism by large shareholders and institutions is still not too prominent, but it is gradually building up. For example, in the US companies like Apple were forced by influential shareholders to distribute more cash to shareholders through buybacks. In the past we have seen many companies diversifying into unrelated areas just because they were flush with funds. A better idea may be to return the cash to shareholders instead and let them decide what they want to do with the excess money. That kind of shareholder activism is only just about beginning to be seen in India.
6. It can help the promoters to consolidate their stake in the company
There are times when the promoters may be worried about their holding in a company going below a certain level. A buyback is an offer and it is up to the shareholders whether to accept or not. If promoters accept the buyback then it maintains their stake and gives cash. Alternatively, if their forfeit the buyback, they are able to increase their stake in the company. This is critical when the company is wary of other companies trying to take them over.
In India buyback is only done through the extinguishing of shares. While the impact on valuations is still debatable, there is no gainsaying that buybacks offer a tax efficient method of returning cash to shareholders!
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