What is a Buyback?
Buyback is the process wherein a company offers to buy its shares owned by the investors, at a premium over the prevailing market price. The offer can be binding or optional to the investors. The trend of buyback offers is usually seen during the bear markets where the promoters feel the stock prices of their companies are undervalued.
The Company Can Buyback Shares From...
● The existing shareholders on a pro-rata basis or
● The open market through a book-building process/stock exchanges or
● Odd lots, that is from shareholders who own a small number of shares or
● The employees of the company pursuant to a scheme of stock option or sweat equity.
Why Companies Go For Buyback?
● Some companies buyback stock to contain the dilution in promoter holding and to block takeover bids.
● Buyback option is also exercised when a company has extra cash reserves and not many investment avenues.
● To enhance its performance metrics such as EPS, ROA and ROE etc and to maintain their target capital structure.
● To reward their investors, companies prefer buyback to dividends, as the dividend attracts taxes at both the company and the investor level.
Regulations For Companies
The government has imposed some restrictions on companies resorting to buyback to protect small investors and also to restrict them from using stock markets as a source of short-term profits.
● Buyback should not exceed 25% of the total paid-up capital and free reserves. While companies can buy-back shares upto 10% of its paid-up equity capital and reserves through a board resolution, companies need shareholders resolution to buyback anything above that.
● A declaration of solvency has to be filed with SEBI and Registrar Of Companies.
● The shares bought back should be extinguished and physically destroyed and the company cannot issue any further buyback upto six months. In a fiscal, the company can normally buyback upto 5% of its outstanding equity without notifying the regulators if the promoter’s stake ranges from 55% - 75%.
Checklist For Investors
While the buyback offers are good entry points for short-term due to arbitrage opportunities arising out of differential in the market price and the buy-back price, investors need to check the following reasons behind the buyback.
● If the P/E ratio of the company is higher than the industry average, the buyback by the company may not be justified. The investors should watch out if the buy-back is being done at the cost of capital expenditure, as it may dampen future prospects.
● The higher the price & the percentage of the buyback, greater is the scope of profits for investors.
The Final Word
Though buyback is an arbitrage opportunity in the short term, investors are advised to look at the company’s fundamentals as well as corporate governance practices before taking a call. One has to also see how many shares the company is buying back and the chances of implementing the buyback announcement as scheduled, without any delay/cancellation. If the company’s fundamentals, corporate governance are strong, the investors may have the advantage of immediate arbitrage and long-term growth potential for their capital.
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