Should you participate in a buyback? Here are the reasons why you should

If the prospects of a company buying back shares are not as bright as they used to be, and the premium is attractive, you should tender your shares

Already very popular in the US, buybacks are now also catching on in India as a means for companies to reward their shareholders. In the first six months of 2018, as many as 28 companies announced buyback plans amounting to about Rs 213 billion, with cash-rich IT companies leading the way. This trend is likely to continue in future as well (see list of companies that have announced buyback plans here.

There are two ways through which companies can return excess cash to shareholders. The traditional way in India has been through dividends. The other route is via buyback, where a company purchases a part of its outstanding shares at a premium to the current market price.

Opting for buyback over dividend

Nowadays, companies are increasingly opting for buybacks instead of dividend payouts, as the latter do not offer much flexibility. "A company can typically offer dividend only once in a year. It can also not change the dividend rate too much from one year to another, as doing so raises expectations among shareholders for subsequent years. On the other hand, a company can conduct a buyback whenever it likes," says K Vaidyanathan, lecturer of finance at the Indian School of Business.  

Buybacks are also more tax-efficient than dividend payouts. The government imposes several taxes on companies that want to distribute profits to their shareholders after they have paid corporation tax. There is the dividend distribution tax of 15 per cent, additional surcharge of 12 per cent, and a cess of 4 per cent. The effective rate comes to 20.56 per cent "In 2016, the government also introduced additional taxes on dividend income in the hands of shareholders at 10 per cent for anyone who receives dividend in excess of Rs 1 million," says Tejas Khoday, chief executive officer and co-founder, Fyers Securities. Due to higher taxes on dividend, companies are increasingly opting for the buyback route.  

Companies nowadays often do small buybacks in lieu of dividends (generally less than 3 per cent of equity). They also announce big buybacks if they believe that the stock price is below reasonable valuation and they have free (idle) cash. "Such buybacks reduce the outstanding equity, while substantially increasing earnings per share and also the stake of investors who hold on to their stocks," says Jatin Khemani, founder and CEO, Stalwart Advisors, a Sebi-registered independent equity research firm. When the number of shares outstanding goes down, the company's earnings get divided among a smaller number of stocks, resulting in improved earnings per share (EPS). Ratios like return on equity (RoE) also look better. All this boosts the company's share price.

Sometimes, in bearish markets, companies use buybacks to support the share price. Buybacks are also a means for management to express faith in the company's prospects. A good example of this was Infosys doing a buyback in the aftermath of Vishal Sikka's departure. After Nandan Nilekani became chairman, the company was keen to convey the message that the stock market had overreacted to Sikka's departure, and that the management remained upbeat about its prospects. So Infosys did a stock buyback, which boosted its stock price.

Do not always view buybacks negatively

Most buybacks are done by large and mature companies which do not need as much growth capital as mid- and small-cap ones do. However, they should not always be perceived negatively. Some businesses are asset-light in nature; that is, they do not require large sums of capital to grow. This could be on account of outsourced manufacturing, as in the case of Symphony Limited. Businesses in the service sector, such as IT companies and credit rating agencies, also do not need much capital. "In such cases, it is better to pay out the majority of earnings rather than hoard it on the balance sheet. The idle cash earns barely 6-7 per cent returns and dilutes the company's return on equity," says Khemani. Among such asset-light businesses, those on the lookout for acquisitions should ideally avoid buybacks. "A company holding on to excess cash, instead of returning it to shareholders, is not positive from the corporate governance perspective as well. There is the risk that the money could be deployed in projects offering a lower rate of return," says Vivek Ranjan Misra, head of fundamental research, Karvy Stock Broking.  

Sometimes, a buyback is also an expression of the management's faith in the company's prospects. "By holding a buybacks, companies try to signal that the stock price is undervalued and hence it is an attractive buy. Sometimes they also try to convey that their cash generation potential will remain robust in the future," says Vaidyanathan.  

To participate or not to?

If the company is doing a small buyback in lieu of dividends and the investor needs the payout, he may tender a proportionate number of shares. In the case of large buybacks, the decision for fundamentals-based, long-term investors should depend on their view regarding the growth prospects of the company and its sector. "If you believe that the signal that the company is trying to convey is credible, and its prospects are bright, hold on to the stock. But if you feel that its growth is slowing down and it cannot find too many avenues to deploy its cash, tendering your shares may be a good idea," says Vaidyanathan.

Investors who trade actively in the markets may compare the price being offered in the buyback with the stock's intrinsic value. If they think that the share price is currently overvalued compared to its intrinsic value, they should sell.  

The decision to tender shares should also factor in the attractiveness of the premium being offered in the buyback and the acceptance ratio (what proportion of tendered shares will be accepted).

Nowadays, most buybacks take place through the stock market where securities transaction tax (STT) is paid on the transaction. In such cases, long-term capital gains are taxed at 10 per cent and short-term ones at 15 per cent.

Decision tree for participating in buybacks

• Whether or not to participate in a buyback should depend on your view of the company and the sector's prospects

• If they are sound, hold on to the stock

• If they are not, tender your shares

• Those who trade more frequently should sell if the current market price is higher than their estimate of the company's intrinsic value

• Do take into account the attractiveness of the premium being offered

• The acceptance ratio will also have a bearing on the extent to which you will be able to cash in on the buyback opportunity