Share Buyback: An Investor’s Guide

The current article focuses on interpreting various aspects related to share buyback like why buyback of shares has increased in recent times, how to interpret when promoters also participate in share buyback, how much premium is justified for share buyback price, when does buyback of shares indicate a red flag.

We have addressed these different aspects of share buybacks by way of answers to investors’ queries asked by them in the Ask Your Queries section of our website.

A share buyback is a method of payment of cash by the company to the shareholders. To understand it completely, investors need to compare it with dividend distribution, which is the other prevalent method of cash payments to shareholders used by companies. Once we understand the different factors influencing share buyback and dividend payments, then we would be able to understand the intentions and the motivations of the companies and their promoters/managements behind such decisions.

Let us first compare share buyback and dividend payments by creating a hypothetical company with a single shareholder. Then we would be able to understand the impact of tax rules on the cash outflows from the company to the shareholders.

Share Buyback vs Dividend Declaration

An investor would remember that a recent change in tax rules in India has put a tax on dividends greater than ₹10 lac (₹1 million) in the hand of shareholders. This tax is over and above the dividend distribution tax. Investors would note that this tax on the dividend income does not apply to share buyback.

Scenario 1: Dividend Distribution

Consider a scenario where a company wants to pay a dividend of ₹100 cr (₹1 billion) to its shareholders, then the following tax implications will come into the picture:

• The company will have to pay a dividend distribution tax of about ₹17 cr to government from the ₹100 cr to be distributed among shareholders. Therefore, the shareholders will get only ₹83 cr as a dividend from the company.
• To illustrate the taxation in the hand of shareholders, let us hypothetically assume that the company has a single shareholder (i.e. the promoter). Therefore, the entire ₹83 cr of the dividend payment will go to this single shareholder.
• As per the recent tax changes, a person who has dividend income above ₹10 lac in a year, has to pay 10% tax on the dividend income above ₹10 lac. Therefore, the shareholder receiving ₹83 cr of dividend income will have to pay about ₹8 cr. as a tax on dividend.

Therefore, an investor would appreciate that in the current scenario a dividend payment of ₹100 cr. from the company would amount to only ₹83 cr. to the shareholder as ₹17 cr is paid by the company to the govt. as dividend distribution tax). Moreover, the shareholder will effectively get only ₹75 cr. as she will have to pay additional ₹8 cr as a tax on dividend income above ₹10 lac. (Please note that these numbers are near approximations to keep the calculations simple).

To put the entire dividend distribution story in perspective, the company suffers an outflow of ₹100 cr. and the shareholders get only ₹75 cr. This is because the govt collects ₹25 cr. in taxes in this transaction (₹17 cr from the company as dividend distribution tax and ₹8 cr. from the shareholders as a tax on dividend income).

Scenario 2: Share Buyback

Now let us assume the second scenario that the company decides to go for share buyback for ₹100 cr:

• In this case, the company announces a buyback of shares worth ₹100 cr and the single shareholder participates in the share buyback. The company buys the shares from this shareholder worth ₹100 cr and makes a payment of ₹100 cr to her bank account.
• In light of the new tax on long term capital gains (LTCG) on equity shares, this shareholder will have to pay tax on the shares sold by her to the company. For simplicity of calculations, let us assume that the cost of the shares submitted by her to the company in the share buyback is zero. This will create the case of maximum LTCG for illustration. In reality, the LTCG will be different depending upon the cost of the submitted shares for the shareholder.
• Assuming zero cost of purchase, the entire amount of ₹100 cr received by the shareholder from the company in the share buyback will become the LTCG. At a rate of 10%, the shareholder will have to pay about ₹10 cr as tax to the govt. and she gets to keep approximately ₹90 cr in her pocket.

Therefore, this second scenario of share buyback illustrates that for a payout of ₹100 cr. from the company, the shareholder gets to keep ₹90 cr. and the payment of tax to the govt is about ₹10 cr.

The tax payout in the case of the share buyback is sharply lower than the total tax payout of about ₹25 cr. in the first scenario of dividend declaration. In case of dividend declaration, the company had a payout of ₹100 cr and the shareholder gets only about ₹75 cr. as the govt collects a total tax of about ₹25 cr in the entire transaction (₹17 cr from the company as dividend distribution tax and ₹8 cr. from the shareholders as a tax on dividend income).

Therefore, currently, buyback of shares are being used by companies as a way to bypass the recent tax on dividends greater than ₹10 lac (₹1 million) in the hand of shareholders, which is over and above the dividend distribution tax. Share buyback does not attract this tax.

How to interpret promoters participating in Share Buyback

Hello Dr. Malik,

I have a query regarding share buyback. There are times when the company announces share buyback. This would logically mean that company thinks that shares are undervalued.

However, sometimes in the buyback the promoters also show the willingness to participate. If the promoters think that shares are undervalued (and hence the buyback) then why would they participate in the buyback? Is this a negative sign?

Best wishes,

Author’s Response:

Hi,

Thanks for writing to me!

You are right that logically a share buyback indicates that the company believes that the shares are undervalued. However, there are many other considerations to be looked at:

1) As illustrated above, currently, buyback of shares are being used by companies as a way to bypass the recent tax on dividends greater than ₹10 lac (₹1 million) in the hand of shareholders. Share buyback does not attract this tax.

Avoiding such tax may be one of the reasons that the promoters are interested in offering shares in the buyback.

2) Other cases of promoters offering their shares in buyback might be that promoters believe that the shares are actually overvalued and they can take out some money from the company, though the takeout would be proportionate to all the investors.

3) In any case the concerns increase when the buyback is announced at a price, which is much higher than the ongoing market price of the stock of the company.

Read: Why Management Assessment is the Most Critical Factor in Stock Investing?

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

Do buyback of shares means that the shares are undervalued?

When do share buybacks become a red flag?

Hello Vijay

1. Why do companies announce buybacks? Without announcing, Can’t they just go and start buying shares as we do?
2. Any times companies announce share buyback at a max price which is higher than the existing market price, so is this not almost certain that share price is undervalued and will definitely increase? It’s almost like declaring that your share is undervalued?
3. When can share buyback be a red flag? Can you give any examples?

Author’s Response:

Hi,

Thanks for writing to me!

1) Companies need to announce buybacks while complying with all the statutory requirements. The law mandates them to announce it in advance.

The buyback offers an alternative way of paying shareholders other than dividends. Nowadays, for many shareholders, buybacks are more tax-efficient than dividends.

Buybacks also present an opportunity for the company to invest the money in its own shares. Buybacks increase the value for remaining shareholders as it increases the EPS for remaining shares.

2) Valuation level of a stock/company has to be decided by the investor on her own without reference to the price point shown by management by way of a buyback. Many times, companies might declare buyback at a much higher price to benefit insiders who wish to sell shares at a much higher price than the current market price, then it would mean that the remaining shareholders are funding the gains of the outgoing shareholders.

Read: How to do Valuation Analysis of Stocks

Buybacks at a very high price might also be announced when the companies are in a rush to reduce the excess number of shares, which they might have issued as part of liberal ESOPs so that EPS can be maintained at pre ESOP exercise levels.

3) Buybacks are a red flag when announced at a much higher price than the current market price. You may find many such examples in Indian markets.

Read: Why Management Assessment is the Most Critical Factor in Stock Investing?

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

How much premium in the Buyback of Shares is justified?

During buyback of shares, what % premium on share price do you consider as much higher.

For example, Allcargo logistics is also buying back shares @195. At the time of the announcement, its shares were quoting at 158. It’s a 25% premium. However, in some companies, promoters do not participate in the buyback, whereas in Allcargo they are participating.

So how to determine whether the buyback is good for the minority shareholder? In one case the company is paying higher premium whereas in other case promoters are participating.

So up to what extent the premium is ok?

And how should we see it when promoters are participating in the buyback (as in the case of Allcargo)?

Regards,

Answer:

Hi,

Thanks for writing to me!

There is no clear cut level for the justified premium. Usually, the buyback price is kept at a premium to the current market price to incentivise the shareholders to sell shares to the company. Here, I believe that any premium of 10-15% may be fine.

The cases, where the shareholders should be cautious, are usually the cases where the buyback price is disproportionately high. I remember a case of GTL Ltd in 2006-07 when it came up with buyback offer at ₹300/- while the share price at the time of the announcement of the buyback was about 150-160/-.

Read: Why Management Assessment is the Most Critical Factor in Stock Investing?

You may read more about our thoughts on the promoters submitting their shares in the buyback in the above discussion in the article.

Most of the times such buybacks where promoters also take part are an alternative to dividend distribution with lower tax impacts.

Hope it clarifies your queries!

All the best for your investing journey!

Regards

Dr. Vijay Malik

Why share buyback by companies have increased recently?

From the above calculations, an investor would appreciate that buyback of shares offers a better proposition to pay cash to shareholders than dividend distribution. This is because, in the case of dividend distribution, about 25% of the total money goes to the govt. whereas in the case of share buyback, the tax payout is about 10%.

However, such decisions of the companies are reactions to the prevalent tax laws. If in future, the tax laws relating to the dividends or share buybacks change, the companies will change their strategies accordingly.

How does the market determine share price after buyback?

What happens to the shares, which are bought back by the company?

Query:

Hi Dr Vijay, Please explain this:

Let us say a company has 100 shares. And the current price of each share is 100. So the market capitalization is 10,000. Now, let’s say the company will buyback 30 shares at 120. So now after buyback company will be left with 70 shares. And let us assume price after buyback will be around 120. So the new market cap becomes 8400.

So my basic question is how market cap adjusts after the buyback. Does the number of shares decrease? what happened to the shares that the company bought. Are those scratched?

Author’s Response:

Hi,

Thanks for writing to us!

The total market capitalization of any company indicates the whole value of its equity as determined by the market. On a gross level, it is independent of the number of shares issued by the company to divide this market capitalization. We are mentioning “on a gross level” because an increasing number of shares improves liquidity, which in turn decreases the liquidity risk/premium on the stock price and in turn result in a small increase in the share price.

To illustrate, if a company has a market cap of Rs. 10,000/-, then on a gross level, the market is indifferent if the company divides this market cap into 100 shares or 200 shares. If a company issues 100 shares, then the market will value these shares at Rs. 100/- each. If the company issues 200 shares, then the market will value these shares at Rs. 50/- each.

In the case of a buyback, on the gross level, the market cap is expected to remain the same. If a company with a market cap of Rs. 10,000/- reduces its shares from 100 to 70 as mentioned by you in your example, then the price of each share should increase from Rs. 100/- before buyback to about Rs. 142/- after buyback (142 = 10,000/70).

This calculation is considering none of the other factors like investors sentiment, macro/microeconomic factors, general bull/bear market sentiment impacts the price. Moreover, the decrease in the number of shares of the company from 100 to 70, will effectively increase the liquidity risk. The increase in liquidity risk/premium will have an impact on bringing the price down a bit.

As the investor would appreciate that a lot of these mentioned factors will keep impacting the share price every day irrespective of the buyback, therefore, the share price at any day post the buyback may not remain at Rs. 142/- but may be higher or lower than Rs. 142/-. However, the underlying guidelines are as detailed above.

The shares, which are bought back by the company are usually kept in abeyance as “Treasury Stock”. They are not available for trading and are, therefore, not counted towards the market cap. The company may decide to extinguish these shares or the company decide to re-issue these shares to the market participants later on to raise more equity capital similar to IPO/FPO or QIP etc.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

Follow up query:

Thank you very much. I have just one more follow up doubt on the same example:-
Since there is a buyback of 30 shares at 120. That means the company is losing market cap of 3600 (ie 120*30) (This amount of money the company lost). So the new market cap should be 10000-3600=6400. Everything else remains the same, so new share price should be 6400/70 = 91? What is wrong in this reasoning?

Regards,

Author’s Response:

Hi,

Thanks for writing to us!

If an investor believes that post buyback there will be a reduction in market cap of the company equal to the amount of money spent in the buyback, then the above-mentioned logic is correct.

However, we believe that the market cap of the stock and the amount of cash on the books of the company are not directly related. Investors would find a lot of cases where the market cap of the company will be lower than the cash available with the company. Many other parameters like the competence of the management, past history of cash utilization, available investment opportunities etc are some of the factors that may determine how the presence/reduction of cash on the books will impact the market cap.

Therefore, we are not sure whether the usage of cash of Rs. 3,600 cr in the buyback will lead to a reduction in the market cap of Rs. 3,600 cr. for the company. However, if an investor is convinced and believes that cash and market cap are directly related then she may assume a reduction of an equal amount of market cap in her calculations.

Hope it answers your queries.

All the best for your investing journey!

Regards

Dr. Vijay Malik

What is the Acceptance Ratio in Share Buyback

Hello Sir,

I would like to understand how one calculates the acceptance ratio in the buyback. I know that it is difficult to get the exact acceptance number, but I just want to know the best possible method of calculating it so that the probability of going wrong is low.

Author’s Response:

Hi,

Thanks for writing to us!

The acceptance ratio is simply a ratio of the number of shares reserved to be bought back from a category of shareholders and the total number of shares held by that category of shareholders.

The acceptance ratio in a buyback scheme is calculated based on the assumption that all eligible shareholders will submit their shares for the buyback. However, if a fewer number of shareholders submit their shares, then the final actual acceptance ratio for the remaining investors may be higher.

The acceptance ratio is mentioned in the buyback scheme document filed by the company with stock exchanges. It is also mentioned by the company in the full-page newspaper advertisement published by the company about the buyback. Companies file a copy of this newspaper advertisement also with the exchange.

All the best for your investing journey!

Regards

Dr. Vijay Malik

It would be a great pleasure to have your views about the buyback of shares. You may share your thoughts about buyback of shares, your experience of submitting shares in the buyback programs of companies, in the comments below.

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Disclaimer

Registration status with SEBI:

I am registered with SEBI as a research analyst.

Details of financial interest in the Subject Company:

I do not own stocks of the companies mentioned above in my portfolio at the date of writing this article.