Mumbai: Tata Consultancy Services Ltd (TCS) said last week that it would buy back roughly 2% of its shares at a 17% premium to prevailing prices. This should ideally have had almost no impact on the company’s share price, given the small reduction in the company’s share capital. But the TCS stock rose 3% after the share buyback announcement, largely because of a peculiarity in India’s share repurchase rules.
The Securities and Exchange Board of India, or Sebi, has mandated that companies reserve 15% of share buyback offers for small shareholders with holdings worth less than ₹ 2 lakh.
These shareholders typically own a fraction of the company’s shares, which essentially means that all or most of the shares they tender in buyback offers get accepted. This provides an incentive for short-term trades that involve buying shares worth ₹ 2 lakh or so just ahead of the buyback, and then tendering them at the announced buyback price, which in this case is at a 17% premium.
As pointed out earlier in this column, Sebi’s misguided policy of protecting small shareholders is being taken advantage of by sophisticated traders who don’t need the regulator to hold their hand. As such, the bizarre quota system should be done away with to remove distortions in the market place.
Of course, this behaviour is being fed by flawed taxation rules, which impose a heavy burden on dividend income. Indian companies are, therefore, turning increasingly to share buybacks to return cash to shareholders in a tax-efficient way.
In TCS’s case, Tata Sons Ltd, with its 72% stake in the company, will take home the lion’s share of the ₹ 16,000 crore share buyback. But it would be bad PR if it walks away with everything; hence, the necessity to buy back shares at a handsome premium and attract other shareholders to tender as well.
If there was no tax arbitrage between dividends and share buybacks, the company’s managers wouldn’t need to worry about these decisions. But as things stand, TCS is buying back shares at a valuation of about 26 times one-year forward earnings, or at a 45% premium to its historical average. This goes against the basic tenet that companies buy back shares when they perceive market valuations to be lower than their fundamental worth.
Besides, buying shares at high valuations reward exiting shareholders at the expense of remaining shareholders, which is again a strange stance for a company.
To conclude, the 3% rise in TCS shares has taken its valuations to 22.5 times estimated FY19 earnings, way ahead of historical average of 18 times one-year forward earnings.
Analysts at Nomura Research said in a note to clients last month that the sharp rise in TCS’s valuations have come about despite cuts in the company’s earnings estimates in the past two years. TCS’s key business in the banking and financial services vertical remains under pressure, which is why expectations on earnings haven’t improved materially. And while the rupee has depreciated sharply this year, this surely can’t be relied upon for a meaningful upgrade in earnings.
Sebi’s share buyback norms may have its quirks; but they are nothing compared to the oddities involved in valuing Indian IT stocks at the moment.
The writer does not have positions in the companies discussed here.