What is the Purpose of a Share Buyback and How can Shareholders Benefit from it ?

Buyback of shares

Deployment of Profits/ Capital

Normally, a company uses its profits and funds for:

Reinvestment: Investment in current/future value creating and innovative projects, salaries, research and development, repayment of existing/excess debt. Retained earnings lay the foundation for investment in future innovation. For instance,Apple Inc. issued a Press Release on January 17,2018, planning to repatriate billions of overseas cash, pay repatriation tax of approximately US$38 billion, open a second campus and expand its current workforce of 84,000 by 20,000, thereby contributing US$350 billionto the US economy over the next 5 years.

Dividend: Distribution of dividend to its shareholders.

Share Buyback: The net surplus capital/funds left after the above, can be used for share buyback from the existing shareholders.

However, each company will either deploy/reinvest the profit/funds in the business or return it to the shareholders in the form of dividend or share buyback depending heavily also on the stage of the company (start-up or established player), industry in which it operates (old economy like steel, energy, consumer durables or new economy like information technology, cloud computing, artificial intelligence, biotech, electric vehicles).

Forms of Buybacks

Share buybacks can be executed as under:

Tender Offer: The shareholders are given a tender offer, whereby they have the option to submit/ tender some/all their shares with a prescribed period at a specified price, which normally is at a premium to the current market price.

Open Market Purchase: The company buys back shares in the open stock market at the market price over a period of time.

The Buyback Impact

When a company repurchases equity shares, the selling shareholders get an infusion of funds. Theoretically speaking, once these shares are off the market, each remaining equity share becomes more valuable since the future profits would be divided/allocated among fewer equity shares i.e., earnings per share (EPS) increases followed by an increase in stock price. However, this perfect cycle will work if and only if the profits/ earnings, and in turn the share price, keeps rising – but, no company can guarantee future profits!

When a company has surplus cash (after repayment of highcost debt) and lucrative growth opportunities and its stock is reasonably priced, a buyback can provide an impetus to the long-term returns of its shareholders.

Why do Companies prefer Buybacks?

Advantages

• Many companies prefer share buybacks over dividends since a buyback is flexible and can be altered (reduced/ increased), if a company is suddenly facing adverse business conditions.
• In contrast to a cut/reduction in dividend, a change in the timing and quantum of buyback is less likely to be considered adversely by the shareholders.
• A buyback or special dividend is better than increasing the ordinary dividend since the latter implicitly increases the expectations of the shareholders to maintain the higher dividend in the future.
• A buyback gives an opportunity to the selling shareholders to invest the funds elsewhere, where they can earn higher returns than what the company is earning. According to the legendary investor, Warren Buffett, CEO of Berkshire Hathaway Inc., “If we reach the point that we can’t create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds.”   Buybacks enable corporate earnings being deployed from old economy companies not needing funds for their business to the shareholders, who in turn can invest it in other companies, who need funds or in industries of the future viz. new economy companies.
• A buyback reduces the risk that the management may use the excess cash to make value-destroying investments, expansion, management glorification. A buyback helps keep pressure on the company management to use capital prudently or return it, so that companies don’t waste shareholders’ funds.
• A company can achieve the optimal/target capital structure via a buyback, especially with debt finance, provided the company has sufficient profits for the interest expense to shield from taxation and the debt servicing won’t entail financial distress in the future.
• From an income-tax perspective, in India, with effect from April 1, 2020, dividend paid by a company to a shareholder is taxable under the Income-tax Act, 1961 (Act) in the hands of the shareholder at the regular rate and is subject to income-tax deduction at source (TDS)/withholding tax, at the applicable rates. 
• However, in the case of buyback of shares by a listed company, the profit/gain to the shareholder is exempt under section 10(34A) of the Act but the company is liable to pay tax on distributed income under section 115QA of the Act on the difference between the repurchase/buyback price and issue price at 20% plus surcharge and cess, as applicable. Similarly, in U.S.A., dividend is taxed as ordinary income while gains from stock buybacks are taxed at a lower rate of incometax at 20%, if the stock is held for more than a year giving rise to long-term capital gains. Therefore, from a shareholders’ perspective, the income-tax under a share buyback can be lower than under dividend payout – a shareholder-friendly way to distribute cash.
• It can support the market price of the share during sluggish/bear market conditions.
• It enables the consolidation of the stake in the company.

Disadvantages

• When a company announces a large buyback, it may be viewed adversely and raise a red flag, especially in a high growth industry. It provides a lens into what the management thinks about the future prospects of the company – the best investment the company can make is in its own shares?
• When an immediate spike in the EPS rather than value creation is the sole reason for a buyback, the selling shareholders gain at the expense of the non-tendering/ continuing shareholders, if the overvalued shares are repurchased.
• A company may overpay for its own shares, if the management’s estimate of the fair value of the shares is overly optimistic.
• If the management and promoters participate in the buyback themselves as tendering shareholders, then it may indicate an underlying weakness in the long-term business of the company.
• Buyback of shares offsets the dilution in EPS once stock options are granted to the employees/ management of the company.
• In recent years, companies have been using borrowings to fund buybacks, reducing equity and hence, increasing leveraging, which can increase the financial risk of the company and its investors in difficult times.
• When management compensation of companies is linked to the growth in EPS on account of the dilution/reduction in the number of outstanding shares in a buyback, they can earn higher compensation under buybacks although the actual profit is the same. To counter this drawback, the Boards of the companies should delink management compensation to EPS, especially under a buyback.
• If a majority of the compensation of senior management consists of stock options/awards, buybacks may be used to prop-up the stock price.

The Right Timing and Price

Smart companies repurchase shares only when the company’s shares are trading below the management’s best estimate of its fair/intrinsic value and no better investment opportunities or returns are available in the business. When a company follows this practice, it will benefit the long-term interest of the non-tendering shareholders at the expense of the tendering /selling shareholders, if the managements estimates are indeed correct.

Conversely, when a company’s shares are expensive and there are no lucrative investment opportunities available in the business, then paying dividend is probably the better option. Some companies and corporations also set parameters for stock buybacks. 

Buyback ROI from a Company’s Standpoint

The buyback return on investment (ROI) = (Reduction in dividend on the repurchased shares + Change in the stock price since the buyback ) /Amount spent on buyback. For a real world analysis, see Buy it Back.

A high/positive ROI, as of Apple Inc. of 48.81% and LVMH Moët Hennessy - Louis Vuitton of 1.59%, indicates pragmatic financial management by buying shares when they are undervalued and investing the funds for prudent use. While a low/negative ROI, as of Berkshire Hathaway Inc. of (5.19%) and Tata Consultancy Services Ltd. of (4.56%), indicates that the company bought its shares at a high price and that the money could have been used wisely, which investors would hate to hear/ observe.

When companies repurchase their share at a prudent time and price then only the company and its shareholders will benefit. We can also infer that the size of a buyback is no guarantee for an increase in earnings or stock price.

Conclusion

When a share buyback is prudently applied for capital allocation after evaluating various options and aligning it with the short/long-term objectives of the company, it can create value for not only the company but also its shareholders. After all, it is the shareholders’ freedom to invest/deploy cash/ money in companies, where it is being used efficiently, thereby with the rise in the productivity of companies, its employees and other stakeholders will also prosper.