We have seen the specialty chemicals major ICI India buying back more than 500,000 shares from the open market on September 21, 2007 . That announcement was preceded by  the announcement of the buy back programme of the pharma MNC – ABBOTT India. Rather it was kind of a surprise for some of the veterans in the market as it was the second buyback in the calendar year 2007.

And these are not all when it comes to buyback announcements in the Indian equity markets. On the one hand we are experiencing a flow of initial public offers in the market raising equity capital and on the other hand there are companies that are buying back their equity capital. This makes all the more important for us to understand what the buyback means and what is in for us?

To start with buyback is one of the several ways to reward the shareholders of the company. It may not be as common as cash dividends, bonuses and rights issues and done in two ways.

Book building
A company 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. Investment bankers are invited to manage the buyback offers. Shareholders are told to tender the shares in the offer if they find the price attractive.

Once the offer closes the shares are accepted for extinction. If the number of shares tendered is more than the maximum number of shares to be bought back in the open offer, the acceptance of shares takes place on proportionate basis. If the number of shares tendered is less than the number of shares stipulated to be bought in the offer, all shares so tendered are accepted.

Open market
If the company intends to buy a very small portion of equity shares the company is more than keen to buy the shares from the open market. Here the company 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.

Why buy back?

Distributing cash:
Companies that have accumulated huge cash over the period of time or have got huge cash in one of business transactions may opt for buy back as an effective means to pay off the shareholders. Instead of special cash dividend it makes sense to go for a buyback.

Cash dividend goes in the hands of all the shareholders and includes those who don't want it. However, buyback on the other hand ensures that only those shareholders will be bid farewell who are in need of cash in exchange of the stock. Also the cash dividends drain the cash away from the company. Buyback on the other hand if done through the open market can be done over a period of time reducing the impact on the cash front.

Also it ensures best use of funds if the company can pick up the stocks from the open market. A golden handshake to the shareholders improves the image of the company in the eyes of the shareholder community, as in most cases the buyback price stipulated is higher than the market price of the stock.

Increasing stake
In the buyback schemes the promoters or the management (insiders) does not participate and the outsiders i.e. the non promoter shareholders are invited to tender their shares. Subsequently, post extinction of the tendered shares the promoter holding goes up. This is a more important reason of doing a buyback in the modern times, when the mergers and takeovers are rampant.

Increasing leverage
In the developed countries companies do borrow to buyback their shares. This way they bring down equity the high cost capital and infuse debt the low cost capital. Other things remaining the same, the increased leverage enhances the profitability of the company.

Support the share price
Companies sometimes use the buyback as a means to support the stock price. Two years ago when the family feud was on full form between the Ambani brothers, Reliance Energy announced a buyback programme at a much higher price than the then prevailing price, to support its stock price.

Open offer and buy back however are two different thing. The former is a statutory requirement whereas buyback is a voluntary action. Open offer is an outcome of changes in management control and the buyback is the function of many factors discussed above.

Buybacks do offer investors with good investment or arbitrage opportunities in the short run.

Article courtesy: umcapitalindia