Mint Explainer: When and why do companies buy back their shares?

The company has to pay a buyback tax of 20% on the difference between market price and the issue price, but the individual is not liable for tax
The company has to pay a buyback tax of 20% on the difference between market price and the issue price, but the individual is not liable for tax

Summary

  • Share buybacks are a tax-efficient way of rewarding shareholders, but may also indicate the company lacks avenues for further growth

This year a number of companies have announced share buybacks, including Wipro, Hinduja Global Solutions, Welspun India, BSE Ltd and, most recently, engineering behemoth Larsen & Toubro (L&T) .

A share buyback is a corporate action that gives investors an opportunity to make money because the company buys back its own shares at a premium to the prevailing market rate. They are of two kinds of buybacks — a tender offer in which a company offers to repurchase its shares at a particular price at which an investor can tender; and an open market offer, in which the company can buy back its shares from the open market over months.

There are many reasons for buybacks. A mature company could have excess cash but lack projects to invest in, and so decide to reward the shareholder. Buybacks are also a more tax-effective way of rewarding shareholders than dividends. The company has to pay a buyback tax of 20% on the difference between market price and the issue price, but the individual is not liable for tax. Dividends on the other hand are subject to tax deductible at source (TDS) and the individual’s income-tax rate.

In theory, buybacks improve valuations as they reduce the number of shares outstanding, thus improving the earnings per share and return on equity. However, in practice it indicates that the company is not using cash for growth. So while the earnings per share rises, the price-to-earnings (PE) multiple – which is growth-driven – contracts, neutralises the buyback’s positive impact on valuation. Companies sometimes resort to buybacks if they feel their stocks are undervalued, especially if they are fundamentally sound. Promoters also use buybacks to consolidate their stakes and fend off hostile takeovers.

Investors should note that they must hold shares of the company on the record date to be eligible for corporate actions such as bonuses, dividends, stock splits and buybacks. The date on which a stock begins to trade without the benefit of a corporate action is the ex-date. Since all shares are now traded on a T+1 settlement cycle, the record date and ex-date are the same. That is, if the record date is Friday, you must buy the share on Thursday, and it will be credited to the trading account on Friday. any shares bought after Friday share will exclude the corporate-action benefit.

Another important aspect that an investors who choose to tender their shares for a buyback must pay heed to is the acceptance ratio. Take the case of L&T, which has sought shareholder approval for a 10,000 crore buyback (3.33 crore shares).

A retail investor, defined as one holding up to 2 lakh of a company’s shares, can buy 66 shares of L&T (3000 x 66 < 2 lakh), rounded off for convenience. At Thursday’s closing price of 2,660, the offer of 3,000 is at a 13% premium, which is an attractive proposition .

However, not all shares will be bought back. The company will declare an acceptance ratio, which is the proportion of shares tendered by a shareholder that it is willing to buy back.

Assume you buy 66 shares at the 27 July closing of 2,660. You pay 1,75,560. Now, if L&T sets a 60% acceptance ratio, the number your of shares it will accept is 40 (rounded off) . The amount you will receive on shares accepted is 1.2 lakh (40 x 3000). The number of shares returned would be 26 and their cost would be 55,560 (1,75,560 - 1,20,000), making the effective cost per share 2,137 (55560/26) . This is the breakeven price of the share . If L&T falls to this price after the buyback, you won’t make any money. If the price is, say, 2,500 after the buyback, you'll make profit of 9,438 profit — (2,500 - 2,137) x 26.

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