PremiumBENGALURU : Before Robert Jackson was appointed as the commissioner of the US Securities and Exchange Commission (SEC), in 2018, he was a professor of law. Often, he would ask his students: “Are we making sure that executive pay gives managers reason to invest in the long-term development of their workforce and their communities? Or are we paying executives to pursue short-term stock-price spikes rather than long-term growth?"
He probably found the answer at the SEC, when he and his staff studied 385 buybacks over 15 months. The findings were surprising. In the 30 days after the buyback announcements, firms enjoyed abnormal returns of more than 2.5%. Twice as many companies had insiders selling in the eight days after the announcement as sell on an ordinary day.
“What we are seeing is that executives are using buybacks as a chance to cash out their compensation at investor expense," he said in a speech on 11 June 2018.
The core job of management is to run a company well and, among other things, deliver financial results that yields attractive returns to investors. The job of management is not to manipulate share prices by resorting to means that have been designed to deal with a few exceptional situations. And in many ways, share buyback programmes amount to manipulating the share price.
In spite of this, many companies—including top Indian firms—both in the past and in recent times, have announced buyback programmes where the buyback price is at a significant premium to the prevailing market price.
Share buyback programmes have skyrocketed after 1980, and according to research by Harvard Business Review, more than half the corporate profits in the US have been spent in share buybacks. The results of these programmes have been questionable. Apple probably is an exception and the share price has seen a boost with every buyback.
However, generally speaking, a company buying back its own shares is not a good sign. No one who understands business or economics would endorse this idea. This is not to say that a share buyback programme is a bad idea under all circumstances or that it cannot be a win-win option under a special set of circumstances.
Even someone like Warren Buffet has employed buyback when he has felt that the shares of his company Berkshire Hathaway Inc., were trading at depressed prices. He goes on to clearly state that the directors of Berkshire Hathaway would authorize a buyback only if the price at which the share was traded was well below the intrinsic value of the share. The intrinsic value of the share is not the share price but the price arrived at as a fair value based on business operations. Such clarity, transparency, and integrity is quite admirable. Probably, no other company that has announced a buyback programme has bothered to clarify the principles that they would go by when evaluating a buyback option. The decision to announce a buyback has often been without any sound logic.
The big questions
Cash is expected to be used imaginatively in growing and redefining the contours of the business, and a growing cash surplus is often an unmistakable sign that the company is running out of ideas.
Excessive cash on the balance sheet makes management look unimaginative and lacking in strategic foresight. Under these circumstances, companies are tempted to indulge in mergers and acquisitions that are non-accretive or venture into new lines of business that are outside of what would normally be considered a strategic fit. Public companies have an additional outlet for getting out of this situation by indulging in a buyback of shares.
A private company could be cash rich because it may have raised more money than it actually needs. On the other hand, a public company could be a cash cow with little or no need for growth capital and no new ideas. Running out of new ideas is not a crime, and it is part of the evolutionary cycle of creative destruction. But it is important to be honest about this and take actions that return capital, which can be deployed by shareholders more productively elsewhere, in a fair and just manner.
This article seeks to explore the nuances of a buyback programme by a public company. Are there a certain set of circumstances under which it is justifiable? What are the factors that tempt companies to initiate a buyback programme, and who are the beneficiaries? Are there vested interests that work quietly, and in tandem, to take out money from such companies in a manner that benefit a select few? Is there an option for a cash rich public company that has limited avenues for meaningfully deploying the surplus cash in a fair manner?
Flawed logic
One option is to pay out a special dividend to all the shareholders. This is a clean option that does not discriminate between different shareholders. Nor can it be seen as an attempt at manipulating the share price. The consequences of such an action impact all shareholders equally. Some cash rich companies exercise this option to transfer money from their balance sheet into the hands of their shareholders, and this is fair.
Not so for a share buyback programme.
The logic offered by companies for a buyback programme is that it would boost the share price and create shareholder value. The argument is fundamentally flawed because this is no way to boost share price. The only way to boost share price is through business performance. The underlying logic for companies with debt is that a buyback would increase ‘leverage’ and this would have a multiplier effect on the earnings per share (EPS) and the share price. The logic is flawed because excessive ‘leverage’ induces financial instability. And what excuse do debt-free companies have!
Even if you accept the logic that this kind of financial engineering to boost the share price can create shareholder value, the share price would get a boost via the buyback programme only if there is a significant increase in the EPS on the remaining shares outstanding (after the buyback).
I will demonstrate through an example that the EPS does get a boost only if the current share price is severely depressed. And this clearly reinforces Warren Buffet’s point about share buyback making sense only when the current share price is well below the intrinsic value of the share. However, most buyback programmes are not announced when share prices are severely depressed. On the contrary, they are executed at severely inflated prices and premiums. One can check this out by looking at some of the recent as well as upcoming buyback programmes, both in India and in foreign markets. Some of the companies are debt free. So, the computation is actually simple.
Here’s the example. Assume a company has no debt on its balance sheet. This is an assumption that simplifies calculations but this is not an unreasonable assumption to make since many tech/IT companies that announce buybacks are debt-free.
Let’s assume that the total earnings in the year is ₹600 crore and there are a total of 100 million shares. Therefore, the EPS is ₹60. Let’s assume that the surplus cash on the balance sheet is earning a return of 10%. If the company’s share price is say ₹1,000 and they announce a programme to buy back 50 million shares at a price of say ₹1,200 (a 20% premium over the prevailing market price), let’s see what happens to the EPS for the balance 50 million shares after the buyback. The amount the company spends on buyback is ₹6,000 crore. This loss of cash from the balance sheet implies a reduction in earnings in the subsequent period of ₹600 crore (the 10% that the surplus cash earned) and hence, the EPS for the remaining 50 million shares drops from ₹60 to zero! So, imagine the plight of shareholders who chose not to tender their shares for sale in the buyback programme.
In real life, the cases will never be this stark but the example has been constructed to make a point—and the point is that the share price is already on the higher side and a buyback, even without a premium on the prevailing price, is not a wise thing to do. In fact, one can’t help wondering why the company would be taking a step like this and who is it intending to benefit, because often the quota for retail investors in a buyback programme could be as small as 15%.
If shareholders want to exit, they can sell at the market price. Why would they want the company to buy out at a premium and why would this company even entertain this outrageous request?
In the above example, if the share price were say ₹100 instead of ₹1,000 and the buyback price were ₹120 instead of ₹1,200, then the EPS after the buyback (on the remaining 50 million shares) would jump from ₹60 per share to ₹108 per share.
Under these circumstances, a buyback is probably prudent because it is benefiting shareholders who have chosen not to sell and it also gives a slight premium to those that want to sell. It’s a win-win.
Therefore, for a debt free company where there is no complication of ‘leverage’, a buyback programme makes sense only if the current share price is severely depressed.
Who benefits?
This above logic applies equally strongly to companies with debt, but the computation is a little more complex. To be precise, it makes sense only if the buyback price is less than the ratio of the current EPS to the returns percentage on the surplus cash.
In this example, the current EPS is ₹60 and the returns percentage on the surplus cash is 10%. So, a buyback programme makes sense only if the buyback price is less than ₹600. A buyback price higher than this would not benefit loyal shareholders. And buyback at a price that is outrageously higher than ₹600 in this case raises questions.
If you evaluate buyback programmes announced by companies against some of these principles, they would fail the test of prudence and fairness. It would almost appear as if the buyback decisions were announced under pressure by influential shareholders.
Over the years, management compensation has been disproportionately indexed on share price and managements have found share buybacks an easier way of boosting share price than creating long-term value. Also, certain influential block of investors tends to benefit from a buyback. All these factors conspire in shaping these programmes at questionable prices.
The Private logic
Now coming to share buyback programmes at private companies. Should private companies look at share buyback? Private companies have a more legitimate reason for announcing a buyback for the simple reason that there is no market for early investors to exit. If a private company is making more cash income than is necessary for funding growth initiatives, and there is no clear visibility to a liquidity event, then creating liquidity for early-stage investors is a fair option.
Even under these circumstances, the buyback price needs to be determined carefully and cannot be the price at which the last investor invested, or if the last investor came in a while back, it cannot be the current fair market value. It has to be lower than that, and even a lower price would give the early investors reasonably good returns.
In conclusion, public companies have absolutely no reason to announce a buyback excepting under the rarest of rare circumstances. If any shareholder finds better avenues for their money than the company in which they hold shares, they are absolutely free to sell their holdings at the prevailing market price and exit. If the company sees no near to medium term means of deploying the surplus cash, they can choose to payout a special dividend.
For instance, if a company has 4 billion shares and wants to unload ₹20,000 crore, they can pay a special dividend of ₹50 per share. This is far more equitable than buying back say 1% of outstanding shares at an outrageous price and benefiting a very small section of share and option holders, to the detriment of the rest.
(TN Hari is advisor at The Fundamentum Partnership)
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