- July 28, 2022
- Posted by: Ramkumar
- Category: Posts
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 #inflation 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 below the fair value.
The stock was trading at Rs.250. However, when i did a DCF 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.
𝐂𝐚𝐧 𝐭𝐡𝐞 𝐟𝐢𝐫𝐦 𝐝𝐨 𝐚 𝐛𝐮𝐲𝐛𝐚𝐜𝐤?
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:
𝟭)𝗧𝗵𝗲 𝘀𝘁𝗼𝗰𝗸’𝘀 𝗰𝘂𝗿𝗿𝗲𝗻𝘁 𝗽𝗿𝗶𝗰𝗲 𝗶𝘀 𝗹𝗲𝘀𝘀 𝘁𝗵𝗮𝗻 𝗶𝘁𝘀 𝗶𝗻𝘁𝗿𝗶𝗻𝘀𝗶𝗰 𝘃𝗮𝗹𝘂𝗲
𝟮)𝗧𝗵𝗲 𝗿𝗮𝘁𝗲 𝗼𝗳 𝗿𝗲𝘁𝘂𝗿𝗻 𝗳𝗿𝗼𝗺 𝘁𝗵𝗲 𝗯𝘂𝘆𝗯𝗮𝗰𝗸 𝘀𝗵𝗼𝘂𝗹𝗱 𝗲𝘅𝗰𝗲𝗲𝗱 𝗮𝗻𝘆 𝗼𝘁𝗵𝗲𝗿 𝗶𝗻𝘃𝗲𝘀𝘁𝗺𝗲𝗻𝘁 𝗼𝗽𝗽𝗼𝗿𝘁𝘂𝗻𝗶𝘁𝗶𝗲𝘀 𝗮𝘃𝗮𝗶𝗹𝗮𝗯𝗹𝗲.
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,𝗺𝗼𝘀𝘁 𝗼𝗳 𝘁𝗵𝗲 𝘀𝗵𝗮𝗿𝗲 𝗯𝘂𝘆𝗯𝗮𝗰𝗸𝘀 𝗳𝗮𝗶𝗹 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 its actual value. To prevent this, many reputed companies do not allow the firm’s management to participate in the buyback.
2)Manage their #eps because buybacks increase EPS when the firm uses debt/cash to finance buybacks. Therefore, EPS improves when the firm’s Earnings/Price > the 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.