Don't forget to rate the article

Unlike years past when bonuses and dividends were the rave on Dalal Street, company share repurchases, allowed in the budget of 1997, are en vogue today. World over too this is a universally popular practice, with stalwarts like Coke, Intel, Chrysler etc. all having done this exercise very successfully. Share buybacks are a way to compensate shareholders with a company's excess cash as well as to enhance shareholder value in many ways.

So why do companies increasingly show a preference for share buybacks and how does it really enhance share holder value. One of the reasons companies are opting for share repurchases over dividends is that shareholders often prefer capital gains over the current income that comes from dividends. In addition, dividends are double taxed since all profits a company earns are taxed at the corporate level. If a company wishes to pay out some of its profits in the form of a dividend, the shareholders also have an income tax liability. In this type of environment, it makes sense to go in for share repurchase activity.

Share repurchases by their very nature decrease the number of shares outstanding. Having fewer shares outstanding not only increases the relative percentage ownership of the remaining shareholders, but also the percentage claim on the company's profits. Said another way, buying back shares increases the earnings per share (EPS) assuming that net income is at least steady. If a company can manage to increase earnings at the same time it is retiring shares, the growth in EPS is compounded.

If a stock's price is its market-assigned price-to-earnings (P/E) ratio multiplied by the earnings per share, it only makes sense that an increase in the EPS would translate to an increased price given a steady P/E multiple. Mathematically, it looks like this:

Stock Price = EPS * P/E Ratio

The above equation helps to explain a stock's valuation when thinking about many other valuation topics, not just share buybacks. In any case, if you increase the right side of the equation, the left side (the stock price) will also appreciate.

Another way to look at why share buybacks tend to increase shareholder value is by thinking about the equilibrium between supply and demand for any given stock. If demand remains constant and the supply (number of shares outstanding) decreases, prices in a free market tend to rise. This is nothing more than simple economics.

Reducing excess cash can also have a dramatic affect on some important efficiency metrics that many investors look at. Still assuming that a company's net income remains constant over time, share buybacks also tend to increase both a company's Return on Assets (ROA) and Return on Equity (ROE).

Share repurchases, unfortunately, are not always successful. One of the worst times a company can buy back shares is when the company's core business is taking a hit. When investors start selling a stock down because of a deterioration in the fundamental health of a company, many times executives (who more times than not own stock options) are enticed by the temporary positive effects that share buybacks may yield. But if the company's future fortunes are truly coming into question, buying back shares often just wastes valuable cash that may be needed to shore up the business down the road. In other words, share buybacks done poorly can exacerbate a bad situation.

From the investors point of view they should look on share repurchases with an inquisitive eye. The idea is to figure out the "why" behind this – there are many reasons a company may want to go in for a share buyback - to help the sagging share price, in times when the market is weak, to indicate that it feels that the shares are intrinsically undervalued by the market and should have higher valuations, to use up its surplus cash effectively. For instance when a company with a high amount of debt goes in for a share repurchase. In this case, buying shares back represents nothing more than an increase in a company's leverage, not really a return of excess cash. Almost by definition a leveraged company's cash is not excess. And perhaps it would be better for debt loaded companies to pay down debt rather than go in for a share buyback.

However a share buyback can be a very good indicator that management has its priorities in place. If a company cannot generate a return on investment on new projects that shareholders could receive from a buyback of shares, then the choice between new investments and the buyback would seem to be pretty clear. However, the benefits of a share buyback depend upon the situation at hand -- the company's growth opportunities and its cost of capital and sources of funding, among other things.

If the objective to revive the sagging stock markets for one and to ward off any takeover attempts by increasing the promoter holding in the Indian companies then the company is merely playing the maths game-i.e. to shore up the EPS and thus the PE. However PE is not just a mathematical calculation and a major determinant of P/E ratio is the intangibles in the company like intellectual assets, brands, good quality of management etc. Since it is only the intangibles which ensure sustained growth for a company, they should be spending their time trying to improve the quality of their intangible assets, if they have any.

The reason behind the buyback defines the effect that this action has on the share price. Obviously the company repurchasing the shares will have to pay a premium over the market price to entice holders to sell. If the buyback is simply a minor adjustment to keep the firm's capital structure in line with stated policy, then the effect is likely to be minimal. Investors already expect the company to make these adjustments from time to time, so the announcement is usually no surprise. In case a company buys back shares outright using its hoard of cash reserves then this is viewed as a bullish signal. The argument is that the firm sees good things happening inside the company that aren't fully reflected in the market price of the stock, suggesting that the shares are a bargain.

So as is with all your investment decisions this decision as to whether to sell back or not, should be taken after careful thought and analysis. Investors will serve themselves well if they know why repurchases work and can spot the difference between what is a bona fide return of capital to them and what is merely a company playing games and leveraging up.

Aru Srivastava

Feedback

Rate this article