- By Niteksh Gupta
Flash Flash Flash!!!!!!!
On 13th December 2022, Paytm's board of directors approved the buyback of its shares up to Rs 850 crores at a maximum price of Rs 810 per share. And this was at an insane premium of about 52% from its at the time of announcement. As soon as the announcement happened, it instigated a critical debate about Paytm's value, business model, and buyback strategy.
Every time this kind of news pops up, as students of business, this gives us a learning opportunity to understand the strategies behind these giant moves in the market.
This article provides a holistic understanding on the big question of buy-back share strategy. Why did Paytm's buyback strategy create so much buzz in the market? Does it benefit retail investors? Or is it yet another strategy to fool the retail investors? And as students of business, what insights do we need to learn about this important happening in the Indian stock market? To understand the sense behind this buyback, we need to know why companies buy back their shares and what benefits they aim to achieve with their buyback.
Reasons Behind Companies Buying Back Shares
The first reason companies buy back their shares is to transfer the benefit of excess cash to their shareholders.
So, let's say company ABC has Rs. 1000 crore in its bank account, and the share price is trading at Rs. 2000 with 1 crore shares floating with the public. Now the company does not need beyond Rs. 200 crore to fund the extra projects; the company has a surplus of Rs. 800 crore this year. So now, ABC may give out Rs. 300 Crore to its shareholders through buybacks. The company would buy back 10 Lakh shares at Rs. 3000 (This is an average). The company is buying back the shares at a 50% premium. So, this way, the shareholders can make a profit. And when done correctly, it gives 3 significant advantages to the stakeholders of ABC.
1. The shareholders of ABC will think that ABC is making such healthy profits that the company is willing to give out Rs. 300 crores in just buyback.
2. It goes to show that ABC cares about its shareholder returns.
3. Despite the share trading at Rs. 2000, the company is willing to buy the shares at Rs. 3000, which clearly shows that the company expects the stock price to shoot beyond Rs. 3000. It tells the market that Rs. 3000 price tag for ABC share is still an undervalued price. As a result, more investors may buy ABC stocks which again benefits the existing shareholders.
So, this way, the buyback strategy can be used to deploy excess cash to benefit and drive confidence among the shareholders.
Now in the real world, in the Indian context, this strategy is deployed by the IT industry companies like Infosys, TCS and Wipro. Wipro completed Rs. 9,500 crores of buyback in 2021, and Infosys announced Rs. 300 crores of share buyback for the 4th time in 5 years. This clearly shows the growth trajectory of the Indian IT industry.
So, the question here arises if a company is not buying back its shares, does that mean that the company is not good? Absolutely Not. This entirely depends on the nature of the company's business. For example, a company like Reliance or Adani Green has thousands of crores of cash, but instead of giving out buybacks, they will use it to make massive investments in telecom and renewable energy because they have a very capital-intensive business. These kinds of companies would choose to deploy their cash into scaling their business and taking risky bets rather than engaging in a share buyback.
The second reason for a company to deploy a buyback strategy is to give out tax-effective benefits to its investors. This is a little complicated; let's understand this using a simple story. There are two ways in which a company can reward its customers, one is by distributing the dividends, and the other is by buying back shares at a higher value than the market price. As per the Indian tax laws, a company's tax liability for dividends is zero, but for buybacks, it is 20%, and including surcharge, it comes to around 23.3%. Now let's use some numbers and understand the difference between these strategies.
In the first scenario, Let's say that company ABC has 10,000 shares in the market trading at Rs. 70, and they decided to give out a dividend of Rs. 10 per share. The company is giving out a dividend of Rs.1 Lakh. Now if Mr Mehta has an income of Rs. 30 Lakh per annum and holds 10 shares of ABC, he would get Rs. 100 in dividends. This dividend income is taxable according to Mr Mehta's tax slab. Mr Mehta makes Rs. 30 Lakh p.a.; his tax slab is 30% and including all cess and surcharge, it comes to around 35.88%. So, Mr Mehta is now liable to pay Rs. 35.80 tax on his dividend income of Rs. 100. Effectively, the amount received by Mr Mehta is Rs. 64.2. The total value of his holdings now is Rs. 700 in share value Plus Rs. 64.2 in dividends.
In the second scenario, ABC takes the buyback route to distribute its profits to its investors. As in the previous scenario, we assume ABC wants to allocate Rs. 1 Lakh. The company will have to pay the buyback tax of 20% and the surcharge on Rs. 1 lakh. The total amount available for buyback is Rs. 1 Lakh minus 20% tax minus surcharge [Rs. 1,00,000 – (20% + surcharge)], resulting in around 23.3%. ABC would have Rs. 1 lakh minus Rs. 23,300 equalling Rs. 76,700 (Rs. 1 Lakh – Rs. 23,300 = Rs 76,700). Now if 10 shares of Mr Mehta get bought back at Rs. 105, which is a 50% premium. Mr Mehta would get a total of Rs. 1050, but here, the catch is Mr Mehta is not liable to pay any tax on the bought-back shares. The total value of his holdings is Rs. 1050.
Therefore, if you see the equations, A shareholder gains more out of a 50% premium buyback than the given tax scenario. This math is specific for a 50% premium and a small dividend. As the numbers keep changing, the better option might also change.
The Third Reason companies buy back their shares is to improve their financial indicators. In the buyback case, the Price-To-Earnings Ratio (PE Ratio) and Earnings Per Share (EPS) are critical indicators. Let's understand these terminologies using a simple example.
Let's say that Infosys has only 100 shares and make a profit of Rs. 5,000. EPS of Infosys, in this case, will be Rs. 5,000 divided by 100, which is Rs. 50, but now, when it buyback 20 of its shares from the public, the total available shares in the market will be 80. The EPS changes from Rs. 5,000 divided by 100 to Rs. 5,000 divided by 80, which is 62.5. If EPS increases, it instils shareholder confidence, and eventually increase in the stock price is seen.
The same thing goes for PE Ratio also. If Infosys had 100 shares with Rs. 5,000 of profit and is trading at Rs. 200 per share. EPS in this would be Rs. 50 per share. Now if we look at the PE Ratio, it is Price divided by Earnings Per Share (EPS) which is Rs. 200 divided by 50, which equals 4. When Infosys buybacks 20 shares, EPS would be 62.5, as calculated in the above paragraph. If the share price doesn't change, the PE Ratio will be Rs. 200 divided by 62.5, which is now 3.2.
So, when the number of shares in the market decreased because of the buyback, the PE Ratio decreased from 4 to 3.2. If you know the stock market basics, the lower the PE Ratio, the more attractive the investment becomes. As a result, shareholder confidence increases. Companies use these buyback strategies, with these reasoning and insight behind them.
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