Definition: The purchase by a listed company of its own shares either in the open market or by tender offers. Sometimes a company has surplus funds that it does not need for its operations. It can use those funds to expand its operations (e.g. buy new businesses) or it can distribute them to stockholders. One-way of distributing funds to shareholders is to have a share buyback, wherein the company buys back some of its shares from existing stockholders.
COMPANIES DO IT FOR FIVE REASONS:
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- To increase the share price
- To rationalise the capital structure – the company believes it can sustain a higher debt-equity ratio
- To substitute the dividend payouts with share repurchases (because capital gains may be taxed at lower rate than dividend income)
- To prevent the dilution of earnings caused, for example, by the issue of new shares to meet the exercise of stock option grants
- To deploy excess cash flow and return it to shareholders
- A company normally buys back shares when it feels the stock is undervalued, or when it has enough cash to reward investors by purchasing the shares at a price higher than the market value.
EXAMPLE OF A SHARE BUY-BACK
Company A has 100 shares issued and makes a profit of $50. This means a shareholder is getting a return of 50 cents a share ($50/100). This is the Earnings per Share or EPS. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $7.50. Suppose that the company buy back 25 shares. A shareholder who retains their shares now earns 67 cents ($50/75) on each share held. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $10.
WHEN A COMPANY SHOULD BUY BACK SHARES
So a company can add value to its shares by buying some of them back:
- Where it has surplus funds;
- Where it can buy them back at a price below intrinsic value.
DON’T BUY BUYBACKS BLINDLY: FOR INVESTORS
Often there is at least a short-term uptick in the stock price after a buyback announcement, and certainly, there is often a bounce up after the buyback itself is actually accomplished. So, some companies might like to divert attention away from a revenue problem by being able to show an increase in the stock price.
Why would there be such an increase? Because a company usually buys back its own shares when it knows the market has seriously undervalued them. After the buyback, the company is still the same company, but there are fewer outstanding shares, so each of them is worth more. And, by decreasing the number of shares outstanding, earnings per share gets a boost.
Yes, if repurchasing is a tactic used to divert attention from faltering fundamentals, then that is a specific buyback stock to avoid. But, there are plenty of examples of companies that bought back stock not to delay the discovery of or to hide problems, but because company management knew the stock was undervalued.
Investors need to be sceptical of companies that announce buyback plans, and months or a year later, show no decrease and sometimes even an increase in the number of shares outstanding. Why would this happen? Because they may have issued more shares to accommodate employee options, they may have bought another company and funded the purchase by using stock, or they may simply have decided not to follow through on the buyback.
Often do not follow through. Just because a company says it will buy back shares doesn’t mean it has to. In fact, 30% of the firms that authorize buybacks never do, says Edward Zajac, professor at Northwestern University.
May merely be soaking up stock options. Howard Silverblatt at Standard & Poor’s says shareholders will see a little real benefit from buybacks because they’re merely offsetting shares issued as employee stock options. For instance, Merrill Lynch plans to buy up to $2 billion of its own stock, which is equivalent to 33 million shares. But that doesn’t cover the 37.5 million shares of employee stock options that Merrill had outstanding in September, which diluted earnings. Companies are “buying back (shares) with one hand and issuing new ones with the other,” Silverblatt says.
Are distracting investors from dividends? By promising a buyback, companies can appease investors and avoid pressure to increase a dividend. New tax laws have made dividends more popular with investors. But companies still prefer buybacks because they are not required to follow through. Silverblatt says dividends paid out by S&P 500 firms increased 15.9% in January, well below the growth in buybacks.
Inflate profitability. Since buybacks reduce the number of shares outstanding, a company can use them to give their per-share earnings a boost when needed, says J. Fred Weston, professor of finance at the University of California, Los Angeles. That makes the business look better when nothing fundamentally has changed. So he advises scepticism. Buybacks are “widely practised,” he says, but often do not “make economic sense.
WHY ARE BUY-BACK SHARES ARE GOOD TO INVEST IN:
- Buybacks anticipate higher share prices. Buybacks are a sign that corporate owners and company management–the ultimate insiders–are confident–even optimistic–about the future and believe the current share price is not only too low but represents a bargain.
- Buybacks increase earnings and the value of shares. A buyback lowers the total number of shares outstanding, which increases the price of every share you own as well as earnings
- Buybacks cut your taxes and maximize your investment. Unlike dividends, buybacks increase your wealth without any immediate tax obligation.
- Buyback stocks can act as a safety net. A company that holds a large number of its own shares has a strong incentive to step in and purchase more shares when prices decline.
- Proponents of buybacks say they benefit investors as share prices typically rise after a buyback is announced. They also reflect a company’s confidence in the future performance of its business and the overall economy.
- Overall growth is not nearly as important as growth per share
Too often, you’ll hear leading financial publications and broadcast talking about the overall growth rate of a company. While this number is very important in the long run, it is not the all-important factor in deciding how fast your equity in the company will grow. Growth per share is.
- When a company reduces the number of shares outstanding by declaring a stock buyback program, each of your shares becomes more valuable and represents a greater percentage of equity in the company.
RELIANCE ON BUYBACK OF SHARES:
India’s largest private business conglomerate Reliance Industries Ltd (RIL) said its board of directors would meet on December 27, a day before its founder Dhirubhai Ambani’s birth anniversary, to discuss buyback of the company’s shares. Reliance shares were hit after Mukesh on Nov. 18 confirmed long-rumoured differences with Anil.
Indian media have run stories about the likelihood of a split in the family-run conglomerate, one of Asia’s most powerful business groups.
Since then the stock has fallen more than 13 per cent, wiping out 90 billion rupees, or $2 billion, in the company’s market value and causing jitters among investors worried about losing more money on a premium blue-chip stock.
The company plans to buy back 52 million shares at 570 rupees (£6.80; $13) apiece, a premium of more than 10% to its current market price. The buy-back price should be payable in cash, up to an aggregate amount not exceeding Rs.29.99 billion. This amount represents the limit of 10 per cent of the total paid-up equity share capital and free reserves of the company as on March 31, 2004.
The statement said the Reliance board had confirmed that the company would not purchase shares under the buy-back from the promoters or from any persons in control through negotiated deals or private arrangement. Funds borrowed from banks or financial institutions will also not be used for the buy-back, it added.
The buy-back is expected to lead to an increase in earnings per share as a consequence of the reduction in an outstanding number of equity shares as well as to an improvement in return on the net worth of the company.
RULES & REGULATIONS TO BE FOLLOWED FOR AND AFTER BUY-BACK:
The board of directors under 77A of the Companies Act, 1956, is authorized to buy back up to 10 per cent of paid-up equity capital and free reserves of the company. The company cannot issue the same kind of securities for six months after the buyback, which can be from existing security holders on the proportionate basis or from the open market. Debt equity ratio cannot be more than 2:1.
REASON FOR BUY-BACK:
1. Company sources said the issue of buyback has been placed before the RIL board for a decision so that speculative activity in Reliance stocks by vested interests could be stopped. The purpose of the buyback of shares is to reduce volatility in price, bring back confidence in the company, decrease the overall cost of capital and increase earning per share due to reduction in number of shares, the sources added.
2. The board hopes the move will reverse a 13% fall in Reliance’s shares since the feud became public last month.
3. Company’s buy-back programme would have a positive impact on share prices and maximise overall shareholder value. The decision to buy-back equity shares is a reflection of the under-valuation of the company’s stock price and the confidence of the management of Reliance Industries in its future growth prospects. It would also have a positive impact on the stock price, contributing to the maximisation of overall shareholder value.
4. RIL said in a statement yesterday that the decision to buy back equity shares is a reflection of the under-valuation of the company’s stock price and the confidence of the management of RIL in its future growth prospects. It would also have a positive impact on the stock price, contributing to maximization of overall shareholder value; it added The company claimed that the buyback would lead to an increase in earnings per share as a consequence of a reduction in outstanding number of equity shares as well as to an improvement in return on net worth of the Company.
WHY ANIL AMBANI DID NOT WANT BUY-BACK???
Anil Ambani had requested Sebi to ask Reliance Industries for disclosures on some points. The first of these is the 7.5 per cent stake in Reliance Industries the Petroleum Trust holds, which is shown as part of the promoters’ holding.
The second is the 4.71 per cent stake in Reliance Industries held by four companies, Reliance Polyolefin, Reliance Aromatics and Petrochemicals, Reliance Energy and Project Development and Reliance Chemicals.
The third point is the potential conflict of interest of Nimesh Kambani, who is a trustee of the Petroleum Trust, which holds a 7.5 per cent stake in Reliance Industries, and is also one of the lead managers to the buyback programme. The trust is shown as a promoter of the company.
Lastly, Anil Ambani raised issues relating to ownership and management and the steps taken to separate the two.
Reliance Industries said in its disclosures on Monday that it had accounted for the shares held by the Petroleum Trust and by the four companies in the “promoters/persons acting in concert” category in line with “the change in the definition of the expression ‘promoter’ in the Sebi (Substantial Acquisition of Shares and Takeover) regulations.
The company also disclosed that Nimesh Kambani, chairman and managing director of J M Morgan Stanley, was one of the trustees of the Petroleum Trust.
It said the sole beneficiary of the trust was Reliance Industrial Investment and Holdings Ltd, a wholly-owned subsidiary of Reliance Industries
SEBI CLEARS RELIANCE BUYBACK OF SHARES
After daylong deliberations, Sebi cleared Reliance Industries Ltd (RIL) buyback of shares at 11 pm on Friday, in the face of objections raised by RIL Vice-Chairman and Managing Director Anil Ambani. According to sources, Ambani put forward a formal objection with Sebi against the buyback, arguing that it is not in the company’s interests.
A point he raised was that one of the merchant bankers to the deal — Nimesh Kambani — also happens to be the trustee of the Petroleum Trust, which holds 7.5 per cent in RIL. When the buyback was put forward to the RIL board, Anil had abstained. He had proposed the cancellation of the Petroleum Trust shares for the buyback or a lower buyback price. Though it has cleared the buyback, Sebi has asked RIL to publish all objections in the offer advertisement.
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