- 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 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.
๐๐๐ง ๐ญ๐ก๐ ๐๐ข๐ซ๐ฆ ๐๐จ ๐ ๐๐ฎ๐ฒ๐๐๐๐ค?
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:
๐ญ)๐ง๐ต๐ฒ ๐๐๐ผ๐ฐ๐ธ’๐ ๐ฐ๐๐ฟ๐ฟ๐ฒ๐ป๐ ๐ฝ๐ฟ๐ถ๐ฐ๐ฒ ๐ถ๐ ๐น๐ฒ๐๐ ๐๐ต๐ฎ๐ป ๐ถ๐๐ ๐ถ๐ป๐๐ฟ๐ถ๐ป๐๐ถ๐ฐ ๐๐ฎ๐น๐๐ฒ
๐ฎ)๐ง๐ต๐ฒ ๐ฟ๐ฎ๐๐ฒ ๐ผ๐ณ ๐ฟ๐ฒ๐๐๐ฟ๐ป ๐ณ๐ฟ๐ผ๐บ ๐๐ต๐ฒ ๐ฏ๐๐๐ฏ๐ฎ๐ฐ๐ธ ๐๐ต๐ผ๐๐น๐ฑ ๐ฒ๐
๐ฐ๐ฒ๐ฒ๐ฑ ๐ฎ๐ป๐ ๐ผ๐๐ต๐ฒ๐ฟ ๐ถ๐ป๐๐ฒ๐๐๐บ๐ฒ๐ป๐ ๐ผ๐ฝ๐ฝ๐ผ๐ฟ๐๐๐ป๐ถ๐๐ถ๐ฒ๐ ๐ฎ๐๐ฎ๐ถ๐น๐ฎ๐ฏ๐น๐ฒ.
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,๐บ๐ผ๐๐ ๐ผ๐ณ ๐๐ต๐ฒ ๐๐ต๐ฎ๐ฟ๐ฒ ๐ฏ๐๐๐ฏ๐ฎ๐ฐ๐ธ๐ ๐ณ๐ฎ๐ถ๐นย 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 theirย #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.
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