Promoters have watched with dismay as the stocks of their companies have plummeted and valuations have collapsed to a fraction of what they were at the beginning of the year. Their solution: Use company funds to buy back shares from the market.
Managements say a buy-back programme is a signal to investors that the stock is undervalued and that they’re willing to support the stock. Theoretically, a buy-back reduces the number of shares, which increases earnings per share which, in turn, should lead to a higher price. It also raises the return on assets and on equity. It’s a way of returning value to shareholders, much like a large dividend. A big enough buy-back can actually support the stock.
(Illustration by: Malay Karmakar / Mint)
That is what seems to have happened with real estate giant DLF, whose stock has outperformed the BSE Realty index since its buy-back programme was announced. But it doesn’t work for every company—much depends on the timing of the announcement, as the performance of the Reliance Infrastructure stock indicates.
More important, whether a company goes in for a stock buy-back should be determined not by notions of the intrinsic value of its stock, but whether it is the best decision in the circumstances. A company with surplus cash can use it to pay off its debt, keep it to tide over bad times, make acquisitions or expand capacity.
Announcing a buy-back is in some ways an admission that the company has no use for the cash and, hence, intends to return it to shareholders. But it makes little sense when it has a sizable amount of debt or needs the funds for projects in the near future. Some analysts say several Indian firms that have announced buy-backs would do well to conserve cash, considering the tough times ahead.
In the US, many companies went to the extent of borrowing to finance buy-backs, which makes little sense for long-term investors. A study by Standard and Poor’s (S&P) found that 320 of the 423 companies in the US S&P Index that repurchased their shares between 1 January 2006 and 30 June 2007 would have done better by investing the money in an index fund benchmarked to the S&P 500.
In short, a buy-back may not always be the best use of a company’s cash. For promoters who are convinced their stock is available at bargain prices, the creeping acquisition route, which requires them to use their own money instead of the company’s cash to increase their stake, is a far more potent signal to shareholders.
Is a buy-back the best use of a company’s cash? Write to us at email@example.com