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Friday, January 8, 2016

Stock Buybacks: A Good Thing or Not?

There are many ways in which a company rewards its shareholders. The most common methods are bonus issues, rights issues, dividends, stock splits and share buybacks.

Bonus issues increase the equity capital. The market price of equity shares gets adjusted according to the issue ratio. So, in theory, there is no gain for shareholders. The company can benefit because the higher capital enables them to borrow more. 

In reality, share price often rises following a bonus issue - particularly for established and financially strong companies - as the lower bonus-adjusted price attracts buyers.

Rights issues increase the equity capital, and sometimes also the reserves if the rights issue is offered at a premium to face value. If the issue price is lower than the market price, shareholders benefit through capital appreciation, even though the market price gets adjusted in the same ratio as the rights issue.

Dividends benefit shareholders, because it is tax-free cash in their hands. For companies, the cash outgo indicates that the company does have sufficient resources to pay dividends. 

If the company has to resort to debt in order to pay dividend (or tax), then it is a 'red flag'. This is why studying the Cash Flow statement in Annual Reports is so important. It gives a clear view of a company's cash position.

Stock splits do not increase the share capital of a company. The face value of equity shares get reduced and the number of shares increase proportionately. Again, in theory, there is no benefit for shareholders.

However, the increased number of shares in demat accounts usually leads to near-term selling. Eventually the selling subsides. The lower market price of the split shares attracts buyers, pushing up the market price. 

Here is an example of how bonus and splits can enhance value for long-term shareholders.

Back in 2002, ITC shares of Rs 10 face value were trading at around Rs 600 or so. If someone had bought 100 shares, his investment would be worth Rs 60000 - not a small sum 14 years ago. 

If s/he had the foresight to hold on till today, the holding would have increased to 3000 shares of Rs 1 face value - thanks to two bonus issues (1:2 and 1:1) and a stock split (10:1).

At the current (corrected) market price of Rs 300, the shareholding would be worth Rs 9 Lakhs - a 15-fold increase, not counting the substantial dividends paid each year.

Share buybacks - sometimes at a premium to market price - reduce the equity capital to the extent of number of shares bought back. The bought-back shares are extinguished. Shareholders get an exit opportunity at a profit.

In case they hold on, the market price tends to rise after the buyback (due to higher EPS and lower P/E) - providing capital appreciation.

Read more about pros and cons of share buybacks in this article.

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