When Should Firms Do Share Buyback?

When Should Firms Do Share Buyback?

In the last month, the stock prices of various firms corrected and fell by 55% to 60%, especially in the metals sector, due to the additional export duty the government imposed to contain rising #inflationย due to high commodity prices. A CFO of a steel firm in India asked if it was the right time to do a share buyback as his firm’s share trades at below the fair value.

The stock was trading at Rs.250. However, when i did aย #dcfย valuation for the firm, the intrinsic value was Rs.760. Further, the stock price crashed by 50% last month, affirming the firm’s belief that it traded at a price far below the fair value.

๐‚๐š๐ง ๐ญ๐ก๐ž ๐Ÿ๐ข๐ซ๐ฆ ๐๐จ ๐š ๐›๐ฎ๐ฒ๐›๐š๐œ๐ค?
In my view, a buyback does not improve firm value but acts as a signal to the shareholders that the management thinks the market has underpriced the stock, thus repurchasing the shares.

Thus, a buyback should satisfy two rules:

๐Ÿญ)๐—ง๐—ต๐—ฒ ๐˜€๐˜๐—ผ๐—ฐ๐—ธ’๐˜€ ๐—ฐ๐˜‚๐—ฟ๐—ฟ๐—ฒ๐—ป๐˜ ๐—ฝ๐—ฟ๐—ถ๐—ฐ๐—ฒ ๐—ถ๐˜€ ๐—น๐—ฒ๐˜€๐˜€ ๐˜๐—ต๐—ฎ๐—ป ๐—ถ๐˜๐˜€ ๐—ถ๐—ป๐˜๐—ฟ๐—ถ๐—ป๐˜€๐—ถ๐—ฐ ๐˜ƒ๐—ฎ๐—น๐˜‚๐—ฒ
๐Ÿฎ)๐—ง๐—ต๐—ฒ ๐—ฟ๐—ฎ๐˜๐—ฒ ๐—ผ๐—ณ ๐—ฟ๐—ฒ๐˜๐˜‚๐—ฟ๐—ป ๐—ณ๐—ฟ๐—ผ๐—บ ๐˜๐—ต๐—ฒ ๐—ฏ๐˜‚๐˜†๐—ฏ๐—ฎ๐—ฐ๐—ธ ๐˜€๐—ต๐—ผ๐˜‚๐—น๐—ฑ ๐—ฒ๐˜…๐—ฐ๐—ฒ๐—ฒ๐—ฑ ๐—ฎ๐—ป๐˜† ๐—ผ๐˜๐—ต๐—ฒ๐—ฟ ๐—ถ๐—ป๐˜ƒ๐—ฒ๐˜€๐˜๐—บ๐—ฒ๐—ป๐˜ ๐—ผ๐—ฝ๐—ฝ๐—ผ๐—ฟ๐˜๐˜‚๐—ป๐—ถ๐˜๐—ถ๐—ฒ๐˜€ ๐—ฎ๐˜ƒ๐—ฎ๐—ถ๐—น๐—ฎ๐—ฏ๐—น๐—ฒ.

The higher the stock undervaluation, the better the return to the continuing shareholders, and we can derive the return (%)= Cost of Equity/(Market price/Fair Value)

In this instance, Price = Rs.250
Intrinsic value = Rs.762
Cost of Equity = 16.13%

If the firm initiates a buyback for Rs.295 at an 18% premium to repurchase 30 million shares and assumes the shareholders tender their shares, the return for the continuing shareholders = 16.13%/(250/762) = 48.45%.

However,๐—บ๐—ผ๐˜€๐˜ ๐—ผ๐—ณ ๐˜๐—ต๐—ฒ ๐˜€๐—ต๐—ฎ๐—ฟ๐—ฒ ๐—ฏ๐˜‚๐˜†๐—ฏ๐—ฎ๐—ฐ๐—ธ๐˜€ ๐—ณ๐—ฎ๐—ถ๐—นย  because companies repurchase shares at a higher price than the stock’s fair value to:

1)Prevent share dilution due to ESOPS. When a firm’s leadership gets its ESOPs vested, it repurchases shares to prevent dilution despite knowing they are repurchasing shares at a higher price than their actual value. To prevent this, many reputed companies do not allow the firm’s management to participate in the buyback.

2)Manage theirย #epsย because buybacks increase EPS when the firm uses debt/cash to finance buybacks. Therefore, EPS improves when the firm’s Earnings/Price >firm’s after tax cost of debt. However, it does not indicate if the share trades below its fair value because EPS does not consider the cost of equity.

Thus, investors must critically assess what motivates a firm to buy back shares because firms’ motives need not align with those of continuing shareholders.



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