When it comes to rewarding the shareholders, cash dividend strikes one's mind. However, when one looks beyond the cash dividends, there are multiple options like stock buy-backs, spinoffs and divestitures. Buy-back of shares or equity repurchase is an effective tool for rewarding the shareholders. This can be primarily done in two ways -- book building and open market repurchase.
In the book building case a firm specifies a price at which it will buy-back shares, the number of shares it intends to repurchase and the period of time for which it will keep the offer open. Shareholders are then invited to submit the shares for repurchase. Services of investment bankers are sought to complete the buyback offers.
Firms that intend to buy a small portion of equity can do so by purchasing the stocks through the open market. Here, the firm comes out with the maximum price at which it is willing to buy shares along with the number of shares it intends to buy back or the funds dedicated for the buy-backs. Revathi equipment last fiscal did one.
Companies have multiple reasons to go for buy-back of shares.
Distributing cash
Companies come across windfall gains or one-time gains on certain business transactions. The cash arising from such action is distributed as special cash dividend. However, there are companies that come out with buy-back of shares with such cash in hand.
The buy-back distributes cash to only those who need it, or who prefer cash to business ownership. The cash dividends reach all shareholders, but all may not be interested in taking cash out of the business as dividend.
Also, cash dividends may drain away the cash at one moment of time. However, the buyback programme can be spread over a period of time, especially in case of buy-back through open market, helping the company deploy cash in the hands of shareholders with better returns for the company.
The company not only distributes the cash but also manages to offer a golden handshake to some shareholders, creating an investor-friendly perception for rest of the investors. Needless to say, the buy-back price is at a premium to the market price.
Increasing stake
This is a more common reason behind share buy-back. If the promoters/management, also known as 'insiders' do not participate in the buy-back of shares, and 'outsiders' tender their share for buy-back, the insiders are left with larger proportionate shareholding in the company post buy-back, offering greater 'control' over the business.
In India, this has been observed in many cases of multinational companies in pharma sector like the buy-back offers from Glaxosmithkline Pharma, Astrazeneca Pharma, etc.
Increasing leverage
A company with a strong balance sheet may borrow funds to buy back equity. This brings in the cash deductible expense of interest, reduction in equity capital and boost the per share earnings, other things remaining the same.
Support share price
Companies that are facing temporary problems use buy-back as a means to support the share price. The buy-back price, being at a premium to the market price, is seen as a 'reference price' for that share. Many may still remember that after the feud between the Ambani brothers the share price of Reliance Energy was depleting very fast. To support and retain the share price, a buy-back was announced.
Open offer & buy back differentiated
Many a times investors confuse open offer as buy back offer. However, there is a fundamental difference between the two. Open offer is more of a statutory requirement and an outcome of changes in ownership structures of companies. On the other hand, the buy-backs are of voluntary nature.
Investor perspective
Companies coming out with buy-backs are perceived as more investor-friendly as most of the investors prefer exit at a 'premium'. However, the investor should watch out if the buy-back is coming at the cost of investment expenditure, as it may dampen future prospects.
In some cases, the buyback announcements are good entry points in the short-term opportunities due to arbitrage opportunities arising out of differential in market price and buy-back price. For companies with good track record and fair corporate governance practices, buy-back creates investor interest.
However, investors must be watchful between the genuine buy-back candidates and unscrupulous companies. Buy-back offers from companies in matured industries with stagnant growth keep the investor interest alive. In the Indian context though, such incidence may be rare due to high economic growth.
One should also look at buy-back to understand the long-term strategies of a company. A company coming out with buy-back offers at regular intervals may be looking at delisting itself by making the company closely held. The MNC pharma companies operating in India can be a good case-study for a savvy investor.
All in all, buy-backs are not just another corporate action but a way of creating and distributing wealth to the shareholders.
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