Share Buyback – The Good, Bad & Ugly

What is Share Buyback?

Introduction

Recently, there has been a slew of share buybacks announced by different companies like TCS, Wipro, Bharat Rasayan, etc. In this blog, we will find out what exactly is share buyback, its positive and negative sides.

Share buyback – The Good, Bad & Ugly

• Share Buyback is a corporate action in which a company buys back its shares from the existing shareholders usually at a price higher than market price.
• When the company buys back, the number of shares outstanding in the market reduces.

There are various reasons for a company to buyback its shares . Let us take a look at these:

Good

• If a company thinks that the current market price of the stock is quite undervalued , it opts to buyback its shares from market.
• This, in turn reduces the outstanding number of shares in market and boosts the EPS.
• Examples of companies buying back shares with this intent are TCS and Wipro.

Bad

• In this case, management buys back its shares mainly to utilize the cash on books as it does not have any good growth opportunities available.
• For example – ITC distributes 80% of its profits in the form of dividends (dividend yield : 5%) and buying back shares.
• Another reason to announce share buyback is to artificially boost EPS & stock price. As number of shares reduce, EPS increases and PE ratio declines, thus making the stock attractive from valuation perspective.

Ugly

• Most of the management compensation packages are linked to earnings per share. Since, number of shares are reduced in a buyback, it results in boosting the EPS.
• Thus here, there can be a conflict of interest between management and shareholders.
• Some companies, inspite of having D/E>1, use the surplus cash to buyback shares inspite of reducing the debt.
• Using debt to finance share buyback is a major red flag .