Share Buybacks: Do They Enhance Shareholder Value?
10/18/2012 9:00 PM Thursday
The typical investor reaction to share buybacks offered by companies is a rush to tender their shares and make a quick buck in the bargain. Are these offers really as rewarding as they are touted to be? Shashikant tells you more.
At the beginning of 2012, India’s most valuable company Reliance Industries (RIL) announced one of the largest buybacks in the history of the Indian capital market. It was to buy back shares worth Rs. 10440 crore at a maximum price of Rs. 870 per share. However, despite such a big announcement, the share price of RIL hardly moved. This happened despite the fact that the maximum price set was at a 12 per cent premium to the prevailing market price.
Conventional wisdom says that share buybacks create value for shareholders by increasing the earnings per share (EPS). By that measure, all other factors remaining the same, the share price of RIL should have gone up. The theory behind this is that as the company buys back equity shares, it reduces the number of shares outstanding. When this happens, the relative ownership stake of each investor increases as there are fewer shares with a claim on the earnings of the company, and hence, the share price should go up.
However, one must not forget that to execute such a buyback, the company uses its cash, which at least earns a riskless rate of interest. Therefore, rational investors will adjust their expectations of future earnings, and thereby, cancel out the impact of a rise in the EPS. Besides this, there are also some other factors that come into play with regard to how the stock price reacts after a buyback announcement.
Another reason given for a buyback is to boost share prices, as a buyback announcement provides a floor to the share price and increases investors’ confidence in the company’s management. However, share buybacks also signal various things about the management. Thus, the correct way to interpret a company’s decision would be to take lessons from past experience by putting it in the current context.
There are examples where we have seen that buybacks have actually backfired for companies competing in a high-growth industry. This is because many a time, such corporate actions are seen as a tacit admission by the management that they see a lesser opportunity to invest the cash available with them.
This is perfectly reflected in the case of Amtek Auto, which came up with a share buyback programme last year. The company had planned a buyback worth Rs. 291 crore. The maximum price at which this was to be executed would be Rs. 200 per share, a good 44 per cent above the share price prevailing at the time of the announcement. However, after the initial movement of about six per cent, the buyback programme could not stop the decline in the share price. The share lost a quarter of its value between the period when the share buyback was announced and the closing date (CD) of the buyback. Even if we look at the performance between the opening date (OD) of the buyback and the closure, the stock was down two per cent.
Some may argue that the impact of such a buyback will get reflected over the next couple of quarters, as the price will respond once the buyback shares get extinguished and the EPS increases. We did not find such an impact, and the share price is down 25 per cent from the price at the completion of the buyback within an approximate time of four months.
So, what should shareholders do in the face of a buyback offer? Are they better off tendering their shares in a buyback offer, or should they wait till the buyback is completed and then sell the shares? As we have seen, in many cases, the company’s share price continues to plunge after a buyback. This acts as a double whammy for the remaining shareholders, as the company ends up spending its funds in the buyback leading to a decline in the book value and the fall in share price also results in an erosion of their value.
Of course, there are also examples where a company’s share prices have spurted after the buyback announcement. For example, Geodesic saw its share price jump up by 20 per cent after its recent buyback announcement. So, what are the factors that differentiate one buyback from the other, and how does an investor choose the wining ones?
Since FY99, we have seen 260 buybacks involving around Rs. 35633 crore. It is normally during the bear phase that a slew of buybacks happen. For example, in FY09 when the market was passing through a bearish phase, 46 buybacks were announced involving Rs. 4218 crore. Similarly, in FY12, when the market was falling, we saw 31 companies (including Reliance Industries) announcing a buyback, involving a sum of Rs. 13765 crore. Here are a few points that investors should look at before deciding whether they should participate in a buyback programme or not. The first factor to watch out for is the amount of cash a company will end up spending on the stock repurchase. If it is spending too much, it will hurt the future operations of the business and if it is spending too less, it will not have the desired impact. The spending will depend upon two things – the price at which the buyback is offered and secondly, the number of shares being bought back.
It has been observed that where the buyback price is at a higher premium to the prevailing market price, the share price has appreciated more between the announcement date (AD) and the closclosing date. For example, Alembic, which announced its buyback programme on November 14, 2008 at a 56 per cent premium to the prevailing market price on the AD, saw its share price appreciate by 45 per cent till the closure of the buyback.
However, it is not only the premium but also the number of shares as a percentage of the total outstanding shares that decides the performance of the stock. One can expect the share prices to go up materially if the company decides to buy a huge chunk of outstanding shares, as we found in the case of Hindustan Unilever (HUL). HUL bought almost 25 per cent of the aggregate of the company’s total paidup equity capital and free reserves in its buyback programme that started on August 23, 2010 and ended on March 28, 2011. The share price went up by nine per cent between the AD and the CD and by a further 20 per cent in the next six months.
Beside this, there are a couple of ratios that should be looked upon, such as the return on capital employed (ROCE) and the debt-equity ratio before participating in a buyback programme. For example, a company like Amtek Auto that has an ROCE of less than five per cent saw its share price plunge after its buyback, as compared to HUL that has an ROCE of more than 90 per cent and thus, witnessed a surge in its share price. Similarly, a company coming up with a buyback and having a higher debt-equity ratio is likely to under-perform going forward.
From the above discussion, it can be concluded that there is not a single ratio or parameter on the basis of which one can judge whether the particular buyback is good or bad, and each case may be unique in itself. Therefore, due consideration should be given to the factors highlighted here before making any decisions. As a final word of caution, it is always better to stay away from companies that come out with such a programme just to prop up their share prices and end up wasting the hard assets of the company in a meaningless buyback.
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