Of late, you may have observed many companies doing buy-backs of their shares from the shareholders. A buy-back is essentially the inverse of an issue of shares (in which companies raise money from the public or their shareholders to meet their capital needs). In a buy-back, a company returns excess money to its shareholders. It can be done either through a fixed price tender offer (as in the recent cases of TCS, Infosys and Wipro), where the offer is made to all shareholders, or through market purchase by the company via the stock exchange. In many ways, a buy-back is similar to a dividend payment, except that here the company returns money only to those shareholders who wish to sell their shares at the price offered by the company. The remaining shareholders, who do not offer their shares, find that their proportionate holding in the company stands increased because the total number of outstanding shares go down after the buy-back. Eventually shareholders need to look at their holdings in a company as a fractional interest in the underlying business – anything that increases their beneficial interest at a discount to intrinsic worth is welcome.
Buy-backs are typically done by companies which generate lot cash and to the extent they have sufficient money left behind after business requirements and normal dividends are taken care of. Such surplus cash can either be paid out as special dividends, or in the form of buy-back of shares from existing shares holders, at near market price or at a premium to current market price. Unlike dividends, where dividend distribution tax (DDT) is payable by the company and hence the total amount available to be paid out as dividend stands reduced to the extent of the DDT, there is no direct tax impact on the company for the buy-back of shares. On the other hand, the value that accretes to investors is not in the form of cash flows directly into their bank account (like a dividend), but indirectly by a combination of purchase of shares at a premium to market price and the resultant increase in the intrinsic per-share value of a company by extinguishing some part of its outstanding shares. Since these shares are tendered by investors through the stock exchange, long term capital gains is tax exempt and short term capital gain is taxed at 15%, making it very tax efficient for the investor too.
Another reason that buy-backs have received a fillip of late, is that the government has made dividends received beyond Rs. 10 lakhs a year, taxable at 10% in the hands of the shareholder. This has presumably been done to ensure that high income earners have to pay a higher tax on the dividends received. This has prompted many promoters to opt for buy-backs rather than pay high dividends as a more tax efficient strategy to pay out to shareholders, and more so for the promoters. The net result has been that some companies are paying out less dividends and instead preferring to pay out the cash to shareholders in the form of buy-backs.
As shareholders of free cash generating companies, we welcome buy-backs because not only does it represent management’s confidence in the business of the company that they are running, it also allows for draining out the excess cash on the balance sheet of the company, which is typically invested in low earning avenues such as fixed deposits or liquid mutual funds. These funds can be better deployed by the investors in either buying more of the company’s stock or in other areas which may yield a better return.