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Buyback: Tread carefully

Sep 25, 2003

When an enterprise goes public, the basic intention is that it wants to generate funds that would be used during the entire lifetime of the company. Thus one would assume that there would never be a need for any company to buyback its shares from the investors, thus returning the capital that it generated while going public. Yet, since buyback has been allowed in India, many companies have opted for the same. So what exactly is a buyback and what should a shareholder do when the company he has invested in decides to buy back its shares. Let us find out. Buyback is a tool in the hands of a company, which it can use in case it finds it necessary to alter its financial structure and also safeguard itself from possible takeover bids. A company can buyback its share in any of the following manners:

  • From the existing shareholders on a proportionate basis through the tender offer.

  • From open market either through book building process or through the stock exchange.

  • From odd lot holders.

In India, the main objectives behind allowing buyback of shares are as follows:

  • Rationalise the capital structure by writing off capital. Thus, if a company has excess capital, it could buy back the same from the market and thus bring its capital to the optimum levels.

  • To pay off the surplus cash not required by the business. If a company does not have a good investment option open before it, it can pay the excess cash back to the shareholders, thus giving them an option to opt out of the company.

  • To thwart any possible takeover bid on the company. A company can make an open offer to buy back its liquid stocks and thus bring down the possibility of any takeover bid.

Although many Indian companies have bought back their shares, MNCs have taken a lead in this regard. Recently, Cadbury's, Otis Elevators, Kodak and Carrier Aircon have bought back shares. MNCs are increasingly opting for buying back their shares because their Indian arms are growing at a faster rate as compared to the parent and hence acquiring a stake in excess of 51% would allow them to consolidate their results with that of their Indian arms.

MNCs: Buyback fever…
Company Offer price (Rs) Market price prior
to buyback offer (Rs)
Current market
price (Rs)
Cadbury's 500 472 484*
Reckitt Benckiser 250 239 248*
Kodak India 350 303 339*
Carrier Aircon 100 55 94*
Otis Elevators 280 NA 318*
Wartsila India 120 69 121
* Price at the time of delisiting
NA: Not available

However, there are some disadvantages for a company when it buys back its shares. The biggest one is that a buyback impairs a company's ability of raising funds. This is on account of two reasons. One, the company is prohibited from making any fresh issues of capital for a specific period from the buyback date. Secondly, as per the Companies Act, the board of directors is required to obtain shareholders approval by way of a special resolution (which is a tedious job) for raising loans in excess of two times the share capital and free reserves. As the share capital declines due to a buyback, so does a company's capacity to borrow freely.

Another issue as far as shareholders are concerned is whether the buyback offer is fairly priced. This doubt has been raised on a number of occasions when MNCs had decided to buyback their shares. There is always a risk that the company may end up acquiring a substantial portion of the free float and finally delist from the stock exchange. The shareholders, in such instances, are better off selling their shares to the company when the buyback offer is open, as they might find it extremely difficult to do so once the stock is delisted. So what should a shareholder do when a company in which he is an investor comes up with a buyback offer?

The first thing that the shareholder should do is to check the share price pattern of the company. If the stock has been traditionally trading at levels lower than the maximum offer price, the share price will go up until it reaches the offer price. If the long term prospects and fundamentals of the company are not very encouraging or if he (the investor) is of the opinion that the offer is overpriced, it would be in his interest to sell the stock in the open market once the stock price rises up to these levels. In this case the investor should opt for open market rather than through company buy back offer, as it is not necessary that the company will buyback his shares. Once the offer ends, the stock price may drop below the maximum offer price and the investor will end up being a loser.

However, if the company is fundamentally strong with good prospects, a shareholder must hold on to his shares irrespective of the buyback offer price, as his holding would entitle him for future returns in form of dividends. Thus, it is in the investor's interest to carefully study the fundamentals and prospects of the company before making a decision as to whether he should accept the buyback offer or not.

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