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What are buy-back offers and how to evaluate them

What are buy-back offers and how to evaluate them
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First Published: Thu, Feb 03 2011. 12 38 AM IST
Updated: Thu, Feb 03 2011. 12 38 AM IST
Buy-back of shares is opposite to the issue of shares by a company. Here instead of giving shares, the company offers to take back its own shares, which are owned by the investors, at a specified price, which is usually at a premium over the current market price.
Buy-backs have gained considerable importance in the past 25 years or so all over the world. In India, the Buy-back of Securities Regulation, passed in 1999, brought about a spate of announcements in this area. Companies such as Crisil Ltd and Piramal Healthcare Ltd have been in the news for offering buy back schemes to investors.
Why companies buy back shares
Surplus cash: When the company has a significant amount of cash and there are not many viable projects on its table and it is also not interested in disbursing cash to the shareholders in the form of dividends, the way out for most of the managements is buying back its own shares.
Internal difference: Sometime shareholders have a contrasting view from the company management. If they are in a majority, they may create an obstacle to the company’s growth. Buy back is a way out for enhancing the controlling stake for the management within the company. The shares bought under this scheme does not go to the promoters, but are held by the company as treasury stock that could be later resold or even used for employees’ stock option schemes.
What it means for you
High share value if you don’t sell back: One of the most common way of measuring the performance of a company is through earnings per share (EPS). A higher EPS means the “intrinsic value” of the share is also high; this, in turn, increases the value held by the investor. By means of the repurchasing route (buy-back), the number of shares outstanding reduces and, thus boosts, the EPS.
Let’s understand through an example. If a company has 10,000 outstanding shares and profit after tax (PAT) of Rs 1 lakh, the EPS would be Rs 10 (PAT/number of shares). If the company buys back 3,000 shares from the market, the new EPS would be Rs 14.29 since the number of shares in the market goes down to 7,000. This means that the shareholders who do not sell back shares to the company will see an increase in the intrinsic value of shares they hold.
Tax shield if you sell: Buy-back offers provide a tax shield for investors. This is because if the company were to declare dividends, investors would have to pay a tax on that.
Modes of buy-back
There are primarily two modes of buy-back—fixed price tender offer and open market buy-back. In the fixed price offer, the company may present shareholders with a formal tender offer, whereby they have the offer to submit a portion of their shares within a certain period, at a certain price, which is normally at a 15-20% premium over the current market price. In the latter, the company announces a band price for buy-back and purchases the shares from the market at the market price, subject to specified rules. In India, the former is preferred because of the high amount of cash involved in buy-back transactions.
How to evaluate buy-back offer price
When should you sell: First, observe the share price movement just before the buy-back. If there is a significant rise, it means there’s something fishy. Second, assess the debt-equity ratio of the firm. If debt is higher than the industry average, it signals that their free cash flow in the future is going to be tight. Third, firms that have raised funds recently and come forward for the buy-back route are not good contenders.
When should you keep shares: If the company has significant amount of cash reserves, you may not want to take the buy-back offer. Another pointer is when the company does not have a huge capital expenditure plan. You can also consider keeping the shares if the share prices do not show a significant upward movement post the buy-back announcement.
Please note that buy-back has no impact on the performance or fundamentals of the company. Hence, investors need to exercise caution while evaluating the buy-back offers.
P. Saravanan is associate professor, finance, Indian Institute of Management, Shillong.
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First Published: Thu, Feb 03 2011. 12 38 AM IST