Understanding Buybacks: The Good, the Bad, and the Ugly

Kotak Insights | Date 21/09/2023

Imagine a company buying its own shares from the market.

This financial move is what we call a buyback. It's like the company saying, "Hey, I like myself, so I'm buying more of 'me'!"

Sounds intriguing, right? Well, it is! And it’s gaining a lot of traction in the Indian markets of late.

Around 21 companies have announced buybacks amounting to ₹26,940 crores in the financial year 2023-24 so far, as per the data by Prime Database.

Buybacks garner attention due to their potential impact on shareholder value, market dynamics, and the company's growth trajectory.

(Explore buybacks with Kotak Neo. Click here for more.)

So, let’s understand them a bit in detail and how you should approach them.

What Are Buybacks?

Imagine it as a company having a pizza, and deciding to buy a slice of it from itself. Strange, right?

Here’s the why, simplified…

Imagine you and your friends own a pizza shop. One day, at your regular meeting, you all discuss ways to make your pizzas even more popular. You realize it's not just about the taste but also about the perceived value of each slice of the pizza. In stock market terms, it’s like a company holding a board meeting with its board of directors.

You find out there’s a shortcut to please your customers. In stock markets, this is similar to a company deciding to buy back its own shares from the stock market.

If your pizza shop is making good profits or you can borrow money at a reasonable rate without burdening the shop, you can go for what we would call ‘buying back slices.’ In stock market terms, it’s akin to a company having sufficient funds or borrowing money to ‘buy its own shares’.

Here’s how it briefly works:

• Board Approval: This is when the company’s board of directors agrees to buy back a certain number of its own shares.
• Open Market: This is like the company instructing a broker to buy back shares from the market.
• Price Determination: The price at which the slices or the shares are bought back is usually set above the prevailing market price to attract shareholders.

And why would you do this?

The Good: Boosting the Share Value

The main reason to buy back slices is to make each remaining slice more valuable. It’s like adding extra cheese to each slice, making it tastier and more appealing.

So, a company buys back shares to reduce the number of shares available. This makes each remaining share more valuable. How?

Here’s the simple math trick:

Let’s say your pizza shop has 100 pizza slices (100 stocks) and makes ₹3000 in profits for the year. This means your earnings per slice or earning per share (EPS) is ₹30.

₹3000 / 100 = ₹30 per slice

Now, say your pizza shop buys back 10 slices or the company buybacks 10 shares. With the same ₹3000 profits, the new EPS calculation is:

₹3000 / 90 = ₹33.33 per slice

In stock market terms, earnings per share or EPS is a crucial metric. By reducing the shares available, the company has effectively raised its EPS.

Taking it a step further, if the market typically values pizza slices from your shop at 20 times the earnings in the market, then the price per slice would have been ₹600 before the buyback, but after the buyback, it would trade at ₹666.67.

20 X ₹30 = ₹600

20 X ₹33.33 = ₹666.67

See how that works?

The share price increases because of the improved EPS. Investors are willing to pay more per share, which boosts the company’s stock price.

Not a bad deal, right?

Companies go for buybacks for various reasons:

• Capital Reinvestment: Reinvesting in the company's own shares is a vote of confidence, signalling that the company perceives its stock as valuable and believes in its future prospects.

• Enhancing Shareholder Value: By reducing the total number of outstanding shares, a company can enhance earnings per share (EPS) and subsequently, the shareholder value.

• Flexibility in Capital Management: Buybacks offer companies the flexibility to allocate capital judiciously. By repurchasing shares, they can effectively utilize excess cash for potentially higher returns compared to traditional investments.

All that sounds good, but there could be more to this buyback business. Let’s find out…

The Bad: Missing the Forest for the Trees

Short-Term Focus: Critics argue that buybacks, often celebrated for their ability to boost stock prices in the short term, may inadvertently shift a company’s focus away from essential long-term investments. It’s like a company becoming overly fixated on pumping up its stock price now, potentially neglecting vital investments for future sustainable growth.

Market Timing Risks: Another concern is the tricky task of timing the market for buybacks. Just as it's hard to predict the ideal moment to toss your pizza dough, it's challenging for companies to gauge the perfect time to repurchase their own shares. Imagine paying a higher price for a fresh batch of pepperoni just before the market price drops. Similarly, companies might end up repurchasing shares at a high price, diminishing the potential benefits for shareholders. This gamble can be a double-edged sword for both the company and its investors.

The Ugly: Market Tactics and Costs

Market Manipulation: In some instances, buybacks can be misused to artificially inflate stock prices, misleading investors and compromising market integrity. When companies use buybacks to inflate their stock prices, it can create a false perception of the company’s actual value, luring investors to buy in under misleading premises.

Opportunity Costs: Lastly, funds allocated to buybacks could instead be directed towards essential areas like research, development, or expansion. This is a missed opportunity, much like choosing not to use top-notch ingredients for your pizza. These investments are the true building blocks of a company's long-term growth and success. By choosing buybacks over these investments, a company may sacrifice potential future growth, hampering its long-term prospects.

In conclusion, if a company executes a well-thought-out and planned share buyback, it can be a strategic use of their cash. This move often leads to an uptick in the stock price and, indirectly, creates value for shareholders - a win-win scenario!

However, one should keep and eye out for potential opportunity costs and debt-funded buybacks.

As a trader or investor, understanding a company's motives behind a buyback and the financial context is essential for informed decisions. It's like understanding the recipe and chef's expertise for a delightful pizza - it enhances the taste. Similarly, comprehending factors driving a company's buyback is key to trading success.

After all, assessing a company's capital allocation skills is crucial as markets favour companies efficiently utilizing excess capital, which ultimately impact stock valuations.

To know about the latest L&T buyback issue, check out this video: All About L&T’s Rs. 10,000 crore Buyback 2023

Until next time…

Happy Learning!

Sources: Kotak Securities, Prime Database

Disclaimer: https://www.kotaksecurities.com/landing-page/researchreport-disclaimer/disclaimer.html