Is Share Buyback a Good Idea?

He probably found the answer in the SEC, when he and his employees studied 385 buybacks over 15 months. The findings were surprising. In the 30 days following the buyback announcements, firms enjoyed unusual returns of over 2.5%. Sales were twice as many as selling in an ordinary day in the eight days after corporate insiders announced.

“What we are seeing is that executives are using buybacks as an opportunity to cash in on their compensation at the expense of investors,” he said in a speech on June 11, 2018.

The main job of management is to keep a company running well and, among other things, to deliver financial results that give attractive returns to the investors. The job of management is not to manipulate share prices by resorting to means designed to deal with certain exceptional situations. And in many ways, the share buyback program is the equivalent of manipulating the share price.

Despite this, many companies—including top Indian companies—have announced buyback programs both in the past and in the recent past, where the buyback price is at a significant premium to the prevailing market price.

Share buyback programs have skyrocketed since 1980, and according to research from Harvard Business Review, more than half of corporate profits in the US are spent in share buybacks. The results of these programs have been questionable. Apple is probably an exception and with every buyback the share price has seen an uptick.

However, generally speaking, a company buying back its shares is not a good sign. No one who understands business or economics would support this idea. This does not mean that the share buyback program is a bad idea in all circumstances or that it may not be a win-win option in particular circumstances.

Even a person like Warren Buffett has used buybacks when he felt the shares of his company, Berkshire Hathaway Inc., were trading at low prices. It explicitly states that the directors of Berkshire Hathaway would authorize the buyback only if the price at which the stock was traded was significantly lower than the intrinsic value of the share. The intrinsic value of a share is not the share price, but the value received as fair value based on business operations. Such clarity, transparency and integrity is commendable. Perhaps, another company that has announced a buyback program hasn’t bothered to clarify the principles when evaluating buyback options. The decision to announce a buyback is often made without any solid reasoning.

big questions

Cash is hypothetically expected to be used to develop and redefine the business profile, and an increase in cash surplus is often a surefire sign that the company is running out of ideas.

Excessive cash on the balance sheet makes management unimaginable and lacking strategic foresight. In these circumstances, companies are tempted to engage in mergers and acquisitions that are non-accelerating or venture into new lines of business that are outside of what would normally be considered a strategic fit. Public companies have an additional outlet to get out of this situation by indulging in buyback of shares.

A private company may be cash-rich because it may have raised more money than it actually needed. On the other hand, a public company may be a cash cow with little or no need for growth capital and no new ideas. Running out of new ideas is not a crime, and it is part of the development cycle of creative destruction. But it’s important to be honest about it and take capital-repaying action that can be deployed by shareholders elsewhere more productively, fairly and justly.

This article attempts to find out the specifics of the buyback program by a public company. Are there certain circumstances under which this is appropriate? What are the factors that drive companies to initiate buyback programs, and who are the beneficiaries? Are there vested interests that work quietly, and together extort money from companies that benefit a select few? Is there an alternative to a cash-rich public company that has limited opportunities to meaningfully deploy surplus cash in an appropriate manner?

flawed reasoning

One option is to pay a special dividend to all shareholders. It’s a neat option that doesn’t discriminate between different shareholders. Nor can it be seen as an attempt to manipulate the share price. The consequences of such action affect all shareholders equally. Some cash-rich companies exercise this option to transfer money from their balance sheets to the hands of their shareholders, and it is appropriate.

Not so for the share buyback program.

The rationale offered by companies for the buyback program is that it will boost the share price and create shareholder value. The logic is fundamentally flawed because it is no way to boost the share price. Business exposure is the only way to increase the share price. The underlying rationale for debt companies is that buybacks will increase ‘leverage’ and have a multiplier effect on earnings per share (EPS) and share price. The logic is flawed as excessive ‘leverage’ induces financial instability. And what excuse do debt free companies have!

Even if you accept the argument that such financial engineering to boost the share price can create shareholder value, the share price will only be boosted through the buyback program if the outstanding shares are paid for. There will be a significant increase in EPS (after buybacks).

I will demonstrate through an example that EPS gets a boost only when the current share price is severely depressed. And it clearly reinforces Warren Buffett’s point about share buybacks only when the current share price is well below the intrinsic value of the share. However, most buyback programs are not announced when share prices are severely depressed. On the contrary, they are executed at severely inflated prices and premiums. This can be checked by looking at some of the recent as well as upcoming buyback programs in both India and overseas markets. Some companies are debt free. So, the calculation is really simple.

Here is the example. Assume a company has no debt on its balance sheet. This is an assumption that simplifies the calculations but it is not an unreasonable assumption as many tech/IT companies that announce buybacks are debt-free.

Let us assume that the total earnings in the year is 600 crores and a total of 100 million shares. Therefore, eps is 60. Assume the surplus cash on the balance sheet is earning a return of 10%. If the share price of the company say 1,000 and they announce a program to buy back 50 million shares at a price of say 1,200 (20% premium over the current market price), let’s see what happens to the EPS for the remaining 50 million shares after the buyback. The amount to be spent on company buybacks is 6,000 crores. This loss of cash from the balance sheet means a decrease in income in subsequent periods. 600 crores (10% of which surplus cash earned) and hence, the remaining 50 million falls from the EPS for the shares 60 to zero! So, imagine the plight of shareholders who decided not to put their shares up for sale in the buyback program.

In real life, cases will never be like this, but the example has been constructed to make a point—and the point is that the stock price is already at a higher level and without a premium to the current price. There is buyback. It’s not a wise thing to do. In fact, one cannot help wondering why the company is taking such a step and who it intends to benefit, as often the quota for retail investors in a buyback program can be as small as 15%.

If shareholders want to exit, they can sell at market price. Why do they want the company to buy at a premium and why will this company even pay heed to this outrageous request?

In the above example, if the share price were say instead of 100 1,000 and the buyback price was instead of 120 1,200, then the EPS after the buyback (on the remaining 50 million shares) will jump from 60 per share to 108 per share.

In these circumstances, a buyback is probably prudent because it benefits shareholders who have chosen not to sell and it also pays a slight premium to those who choose to sell. It’s a win-win.

Therefore, for a debt-free company where there is no ‘leverage’ complication, a buyback program makes sense only when the current share price is severely depressed.

Who benefits?

This above logic applies equally to companies with debt, but the calculations are a bit more complicated. To be precise, this only makes sense if the buyback price is less than the ratio of current EPS to return on surplus cash as a percentage.

In this example, the current EPS is 60 and the return percentage on surplus cash is 10%. Therefore, a buyback program only makes sense if the buyback price is . be less than 600. The repurchase price above this will not benefit the loyal shareholders. And buyback at a price that is outrageously . More than In this case 600 questions arise.

If you evaluate buyback programs announced by companies against some of these principles, they will fail the test of prudence and fairness. It would almost seem as though the buyback decisions were announced under pressure from influential shareholders.

Over the years, management compensation has been indexed disproportionately to the share price and management has found share buybacks to be an easier way to raise the share price than to create long-term value. In addition, some impressive block of investors benefit from the buyback. All these factors are involved in shaping these programs at dubious prices.

private argument

Now coming to share buyback program in private companies. Should private companies consider share buybacks? Private companies have a more legitimate reason to announce buybacks, the simple reason being that there is no market for early investors to exit. If a private company is making more cash income than necessary for growth initiatives, and there is no clear visibility for a liquidity event, creating liquidity is a reasonable option for early-stage investors.

Even in these circumstances, the buyback value needs to be determined carefully and may not be the price at which the last investor invested, or if the last investor came in some time ago, it may not be the current fair market value. Is. It should be less than that, and the low price will also give a pretty decent return to the early investors.

Finally, public companies have no reason to announce buybacks except in the rarest of rare circumstances. If a shareholder finds a better way for their money than the company in which they hold the shares, they are absolutely free to sell their stake at the current market price and exit. If the company does not see near medium-term means of deploying surplus cash, they may choose to pay a special dividend.

For example, if a company has 4 billion shares and wants to unload 20,000 crore, they may pay a special dividend 50 per share. This is far more equitable than buying back 1% of the outstanding shares at an outrageous price and making up for the loss of the rest, benefiting a very small section of share and option holders.

(TN Hari is an advisor to Fundamentum Partnership)