The Chartered Accountant Journal • Capital Market Vol. 69 | No. 2 | August 2020 | Pages 75–81 (Journal pp. 223–229)

Buyback of Shares – A Capital Allocation Tool

By CA. Samir Mogul* & Isha Mogul | (*The author is a member of the Institute. He can be reached at eboard@icai.in)

“Over the last few years, corporations/companies in India and worldwide have been increasingly buying back their own shares. However, ever since the outbreak of the novel coronavirus (COVID-19) pandemic, prices of stocks have crashed. The pandemic has forced companies to either temporarily shut down or drastically reduce their business due to government directives. These companies are losing revenue, incurring losses and facing cash flow issues. Consequently, companies are now reducing/pruning their dividend and/or buyback plans. But, ideally when should a company buyback its shares and does it benefit the company and its shareholders? The article talks about buyback of shares used as a capital allocation tool for creating value for the company & its shareholders at the right time. Read on to know more…”

Deployment of Profits/Capital

Normally, a company uses its profits and funds for:

• Reinvestment: Investment in current/future value creating and innovative projects, salaries, research and development, repayment of existing/excess debt. Retained earnings lay the foundation for investment in future innovation. For instance, Apple Inc. issued a Press Release on January 17, 2018, planning to repatriate billions of overseas cash, pay repatriation tax of approximately US$38 billion, open a second campus and expand its current workforce of 84,000 by 20,000, thereby contributing US$350 billion to the US economy over the next 5 years¹.
• Dividend: Distribution of dividend to its shareholders.
• Share Buyback: The net surplus capital/funds left after the above, can be used for share buyback from the existing shareholders.

However, each company will either deploy/reinvest the profit/funds in the business or return it to the shareholders in the form of dividend or share buyback depending heavily also on the stage of the company (start-up or established player), industry in which it operates (old economy like steel, energy, consumer durables or new economy like information technology, cloud computing, artificial intelligence, biotech, electric vehicles).

Buybacks

In the last 22 years, nearly 557 Indian companies have announced and bought back its equity shares to the tune of Rs. 2,14,095 crores (nearly US$28.423 billion in value terms on March 31, 2020). The largest buyback of Rs. 55,587 crores (nearly US$8.0120 billion in value terms on March 31, 2019) covering 63 companies was in financial year 2018-2019 itself².

Similarly, in U.S.A. between 2009-2018, 465 listed companies in the S&P 500 Index spent US$4.3 trillion on buybacks and US$3.3 trillion on dividends over the decade. In 2019, corporations listed in the S&P 500 Index spent US$0.73 trillion on buybacks (2.72% of the market capitalisation US$26.76 trillion) and US$0.49 trillion on dividends (1.81% of the market capitalisation US$26.76 trillion).

The corporate tax rate for large companies in India is 30%. Previously, U.S.A. tax authorities levied a 35% federal income tax rate on companies’ earnings globally, but allowed them to defer paying taxes on offshore income until they returned/repatriated it to the U.S.A. The tax reform announced by President Donald Trump in 2017 entailed a reduction in the corporate tax rate to 21% and repatriation of US$2.5-4 trillion of profits, that American corporations had parked overseas (deferred foreign income) in order to avoid the corporate tax of 35%. These companies could bring in the money by paying a one-time lower tax rate, being one-time rate of 15.5% on cash and 8% on other assets. This provided a boost to companies to return funds to the shareholders, especially through stock buybacks.

So, why are so many companies returning funds back to its shareholders through share buybacks?

Forms of Buybacks

Share buybacks can be executed as under:

• Tender Offer: The shareholders are given a tender offer, whereby they have the option to submit/tender some/all their shares with a prescribed period at a specified price, which normally is at a premium to the current market price.
• Open Market Purchase: The company buys back shares in the open stock market at the market price over a period of time.

The Buyback Impact

When a company repurchases equity shares, the selling shareholders get an infusion of funds. Theoretically speaking, once these shares are off the market, each remaining equity share becomes more valuable since the future profits would be divided/allocated among fewer equity shares i.e., earnings per share (EPS) increases followed by an increase in stock price. However, this perfect cycle will work if and only if the profits/earnings, and in turn the share price, keeps rising – but, no company can guarantee future profits!

When a company has surplus cash (after repayment of high-cost debt) and lucrative growth opportunities and its stock is reasonably priced, a buyback can provide an impetus to the long-term returns of its shareholders.

“When a company has surplus cash (after repayment of high-cost debt) and lucrative growth opportunities and its stock is reasonably priced, a buyback can provide an impetus to the long-term returns of its shareholders.”

Why do Companies prefer Buybacks?

Advantages	Disadvantages
Many companies prefer share buybacks over dividends since a buyback is flexible and can be altered (reduced/increased), if a company is suddenly facing adverse business conditions. In contrast to a cut/reduction in dividend, a change in the timing and quantum of buyback is less likely to be considered adversely by the shareholders. A buyback or special dividend is better than increasing the ordinary dividend since the latter implicitly increases the expectations of the shareholders to maintain the higher dividend in the future. A buyback gives an opportunity to the selling shareholders to invest the funds elsewhere, where they can earn higher returns than what the company is earning. According to the legendary investor, Warren Buffett, CEO of Berkshire Hathaway Inc., “If we reach the point that we can’t create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds.”³ Buybacks enable corporate earnings being deployed from old economy companies not needing funds for their business to the shareholders, who in turn can invest it in other companies, who need funds or in industries of the future viz. new economy companies. A buyback reduces the risk that the management may use the excess cash to make value-destroying investments, expansion, management glorification. A buyback helps keep pressure on the company management to use capital prudently or return it, so that companies don’t waste shareholders’ funds. A company can achieve the optimal/target capital structure via a buyback, especially with debt finance, provided the company has sufficient profits for the interest expense to shield from taxation and the debt servicing won’t entail financial distress in the future. From an income-tax perspective, in India, with effect from April 1, 2020, dividend paid by a company to a shareholder is taxable under the Income-tax Act, 1961 (Act) in the hands of the shareholder at the regular rate and is subject to income-tax deduction at source (TDS)/withholding tax, at the applicable rates. However, in the case of buyback of shares by a listed company, the profit/gain to the shareholder is exempt under section 10(34A) of the Act but the company is liable to pay tax on distributed income under section 115QA of the Act on the difference between the repurchase/buyback price and issue price at 20% plus surcharge and cess, as applicable. Similarly, in U.S.A., dividend is taxed as ordinary income while gains from stock buybacks are taxed at a lower rate of income-tax at 20%, if the stock is held for more than a year giving rise to long-term capital gains. Therefore, from a shareholders’ perspective, the income-tax under a share buyback can be lower than under dividend payout – a shareholder-friendly way to distribute cash. It can support the market price of the share during sluggish/bear market conditions. It enables the consolidation of the stake in the company.	When a company announces a large buyback, it may be viewed adversely and raise a red flag, especially in a high growth industry. It provides a lens into what the management thinks about the future prospects of the company – the best investment the company can make is in its own shares? When an immediate spike in the EPS rather than value creation is the sole reason for a buyback, the selling shareholders gain at the expense of the non-tendering/continuing shareholders, if the overvalued shares are repurchased. A company may overpay for its own shares, if the management’s estimate of the fair value of the shares is overly optimistic. If the management and promoters participate in the buyback themselves as tendering shareholders, then it may indicate an underlying weakness in the long-term business of the company. Buyback of shares offsets the dilution in EPS once stock options are granted to the employees/management of the company. In recent years, companies have been using borrowings to fund buybacks, reducing equity and hence, increasing leveraging, which can increase the financial risk of the company and its investors in difficult times. When management compensation of companies is linked to the growth in EPS on account of the dilution/reduction in the number of outstanding shares in a buyback, they can earn higher compensation under buybacks although the actual profit is the same. To counter this drawback, the Boards of the companies should delink management compensation to EPS, especially under a buyback. If a majority of the compensation of senior management consists of stock options/awards, buybacks may be used to prop-up the stock price.

Advantages

Disadvantages

Many companies prefer share buybacks over dividends since a buyback is flexible and can be altered (reduced/increased), if a company is suddenly facing adverse business conditions.
In contrast to a cut/reduction in dividend, a change in the timing and quantum of buyback is less likely to be considered adversely by the shareholders.
A buyback or special dividend is better than increasing the ordinary dividend since the latter implicitly increases the expectations of the shareholders to maintain the higher dividend in the future.
A buyback gives an opportunity to the selling shareholders to invest the funds elsewhere, where they can earn higher returns than what the company is earning. According to the legendary investor, Warren Buffett, CEO of Berkshire Hathaway Inc., “If we reach the point that we can’t create extra value by retaining earnings, we will pay them out and let our shareholders deploy the funds.”³ Buybacks enable corporate earnings being deployed from old economy companies not needing funds for their business to the shareholders, who in turn can invest it in other companies, who need funds or in industries of the future viz. new economy companies.
A buyback reduces the risk that the management may use the excess cash to make value-destroying investments, expansion, management glorification. A buyback helps keep pressure on the company management to use capital prudently or return it, so that companies don’t waste shareholders’ funds.
A company can achieve the optimal/target capital structure via a buyback, especially with debt finance, provided the company has sufficient profits for the interest expense to shield from taxation and the debt servicing won’t entail financial distress in the future.
From an income-tax perspective, in India, with effect from April 1, 2020, dividend paid by a company to a shareholder is taxable under the Income-tax Act, 1961 (Act) in the hands of the shareholder at the regular rate and is subject to income-tax deduction at source (TDS)/withholding tax, at the applicable rates. However, in the case of buyback of shares by a listed company, the profit/gain to the shareholder is exempt under section 10(34A) of the Act but the company is liable to pay tax on distributed income under section 115QA of the Act on the difference between the repurchase/buyback price and issue price at 20% plus surcharge and cess, as applicable. Similarly, in U.S.A., dividend is taxed as ordinary income while gains from stock buybacks are taxed at a lower rate of income-tax at 20%, if the stock is held for more than a year giving rise to long-term capital gains. Therefore, from a shareholders’ perspective, the income-tax under a share buyback can be lower than under dividend payout – a shareholder-friendly way to distribute cash.
It can support the market price of the share during sluggish/bear market conditions.
It enables the consolidation of the stake in the company.

When a company announces a large buyback, it may be viewed adversely and raise a red flag, especially in a high growth industry. It provides a lens into what the management thinks about the future prospects of the company – the best investment the company can make is in its own shares?
When an immediate spike in the EPS rather than value creation is the sole reason for a buyback, the selling shareholders gain at the expense of the non-tendering/continuing shareholders, if the overvalued shares are repurchased.
A company may overpay for its own shares, if the management’s estimate of the fair value of the shares is overly optimistic.
If the management and promoters participate in the buyback themselves as tendering shareholders, then it may indicate an underlying weakness in the long-term business of the company.
Buyback of shares offsets the dilution in EPS once stock options are granted to the employees/management of the company.
In recent years, companies have been using borrowings to fund buybacks, reducing equity and hence, increasing leveraging, which can increase the financial risk of the company and its investors in difficult times.
When management compensation of companies is linked to the growth in EPS on account of the dilution/reduction in the number of outstanding shares in a buyback, they can earn higher compensation under buybacks although the actual profit is the same. To counter this drawback, the Boards of the companies should delink management compensation to EPS, especially under a buyback.
If a majority of the compensation of senior management consists of stock options/awards, buybacks may be used to prop-up the stock price.

The Right Timing and Price

Smart companies repurchase shares only when the company’s shares are trading below the management’s best estimate of its fair/intrinsic value and no better investment opportunities or returns are available in the business. When a company follows this practice, it will benefit the long-term interest of the non-tendering shareholders at the expense of the tendering/selling shareholders, if the managements estimates are indeed correct.

Conversely, when a company’s shares are expensive and there are no lucrative investment opportunities available in the business, then paying dividend is probably the better option.

Some companies and corporations also set parameters for stock buybacks. In the case of Berkshire Hathaway Inc.:

“Common Stock Repurchase Program

For several years, Berkshire had a common stock repurchase program, which permitted Berkshire to repurchase its Class A and Class B shares at prices no higher than a 20% premium over the book value (emphasis supplied) of the shares. In 2018, Berkshire’s Board of Directors authorized an amendment to the program, permitting Berkshire to repurchase shares any time that Warren Buffett, Berkshire’s Chairman of the Board and Chief Executive Officer, and Charles Munger, Vice Chairman of the Board, believe that the repurchase price (emphasis supplied) is below Berkshire’s intrinsic value, conservatively determined (emphasis supplied).

The program does not specify a maximum number of shares to be repurchased or obligate Berkshire to repurchase any specific dollar amount or number of Class A or Class B shares and there is no expiration date to the repurchase program. Berkshire will not repurchase its common stock if the repurchases reduce the total value of Berkshire’s consolidated cash, cash equivalents and U.S. Treasury Bills holdings to less than $20 billion.”⁴

The Total Assets of Berkshire on December 31, 2019 was US$817.7290 billion.

“Conversely, when a company’s shares are expensive and there are no lucrative investment opportunities available in the business, then paying dividend is probably the better option.”

How Much is Right?

The number of shares and amount spent on the buyback depends on it’s purpose.

• Capital Restructuring:

If the main objective is to reach a target capital structure, then the number of shares is a function of the company’s market value, its share price, current/target debt-equity ratio.

Let’s take a company having market value of debt and equity of Rs. 20 crores and Rs. 80 crores respectively, aggregating to Rs. 100 crores, and its stock price is Rs. 20/share. The company plans to change its capital structure (debt:equity) from the existing 20:80 to 30:70. The company can issue fresh debt of Rs. 10 crores and buyback 50,00,000 shares (12.50% of the shares outstanding) at Rs. 20/share. However, with the issue of fresh debt of Rs. 10 crores, the interest thereon at say 15% p.a. will save income-tax at say 35% of Rs. 0.525 crores or Rs. 0.15/share. Thus, the price of share will/should also rise by Rs. 0.15/share to Rs. 20.15/share. With this, the market value of debt and equity would be Rs. 30 crores and Rs. 70.525 crores aggregating to Rs. 100.525 crores and the debt-equity ratio would become 29.84:70.16 i.e., marginally different from the target of 30:70. We have ignored transaction cost of issuing fresh debt and share buyback. Therefore, a company needs to plan accordingly to get the right mix of fresh debt and number of shares to buyback to achieve the target capital structure.

• Value Extraction:

Let’s consider another case, where the board of XL Ltd. feels that the fair value of the company’s net assets is Rs. 1,000 crores, with 50 crores equity shares outstanding, and in turn, the fair value/equity shares is Rs. 20/share. However, the current stock price is Rs. 15/share (25% discount). XL Ltd. decides to buyback 5 crores equity shares (10% of the existing shares outstanding) and expending Rs. 75 crores thereon. Now, with 45 crores shares outstanding, there is a possibility of an increase in the stock price of Rs. 5.56/share [{(Rs. 1,000 crores – Rs. 75 crores)/(50-5 crores equity shares)} – Rs. 15] or 37.04% of the current stock price (Rs. 5.56/Rs. 15 per share). Thus, irrespective of the movement in the stock price, the fair value/share does marginally rise from Rs. 20/share to Rs. 20.56/share (just 2.80%) by buying back 10% of the shares outstanding at a discount of 25%.

Buyback ROI from a Company’s Standpoint

The buyback return on investment (ROI) = (Reduction in dividend on the repurchased shares + Change in the stock price since the buyback ) / Amount spent on buyback. For a real world analysis, see Buy it Back.

A high/positive ROI, as of Apple Inc. of 48.81% and LVMH Moët Hennessy - Louis Vuitton of 1.59%, indicates pragmatic financial management by buying shares when they are undervalued and investing the funds for prudent use. While a low/negative ROI, as of Berkshire Hathaway Inc. of (5.19%) and Tata Consultancy Services Ltd. of (4.56%), indicates that the company bought its shares at a high price and that the money could have been used wisely, which investors would hate to hear/observe.

When companies repurchase their share at a prudent time and price then only the company and its shareholders will benefit.

We can also infer that the size of a buyback is no guarantee for an increase in earnings or stock price.

The Impact of the Coronavirus Pandemic

The novel coronavirus disease (COVID-19), which is an infectious disease caused by a newly discovered coronavirus, emerged in Wuhan, Hubei Province, China in December 2019. COVID-19 can be severe, and some cases have caused death.

On March 11, 2020, “Deeply concerned both by the alarming levels of spread and severity, and by the alarming levels of inaction, WHO made the assessment that COVID-19 can be characterized as a pandemic.”⁵

COVID-19 cases, which have spread across 213 countries as per the World Health Organization (WHO)⁶, is summarised hereunder (see The COVID-19 Pandemic):

The COVID-19 Pandemic
Country	Population (in billion) 1	Confirmed Cases 2	Infection Rate 3 = 2/1	Deaths 4	Mortality Rate 5 = 4/2
Overall	7.8000	44,34,653	0.06%	3,02,169	6.81%
U.S.A.	0.3308	13,82,362	0.42%	83,819	6.06%
The United Kingdom	0.0679	2,36,715	0.35%	33,998	14.36%
China	1.4393	84,478	0.01%	4,644	5.50%
India	1.3800	85,940	0.01%	2,752	3.20%

People across the world are under lockdown with business and economic activities at its near lows or standstill, and governments offering stimulus packages for recovery with restrictions on dividends and stock buybacks on companies availing these packages.

In mid/end of March 2020, stock markets like the Dow Jones Industrial Average (U.S.A.), Euronext 100 (Europe) and S&P BSE Sensex (India) fell by 38.4020%, 39.8976% and 39.3505% respectively from their peak in January/February 2020. In this scenario, companies with strong balance sheets and having surplus cash, should have or can use this as an opportunity to buyback it’s stock at the right (depressed/low) price (refer column 10 of Buy it Back).

Conclusion

When a share buyback is prudently applied for capital allocation after evaluating various options and aligning it with the short/long-term objectives of the company, it can create value for not only the company but also its shareholders. After all, it is the shareholders’ freedom to invest/deploy cash/money in companies, where it is being used efficiently, thereby with the rise in the productivity of companies, its employees and other stakeholders will also prosper.

Works Cited

¹ “Apple accelerates US investment and job creation.” Apple, Press Release dated January 17, 2018, https://www.apple.com/newsroom/2018/01/apple-accelerates-us-investment-and-job-creation/

² “Database Coverage: 1998-99 to 2019-20 (22 Years).” Prime Database, https://www.primedatabase.com/buy_demo.asp. Accessed on April 25, 2020.

³ “An Owner’s Manual.” Berkshire Hathaway Inc. 2008 Annual Report, June 1996, p. 91.

⁴ Berkshire Hathaway Inc. 2019 Annual Report, 2019, p. K-29.

⁵ “WHO Timeline - COVID-19.” World Health Organization, April 27, 2020, https://www.who.int/news-room/detail/27-04-2020-who-timeline---covid-19. Accessed on May 17, 2020.

⁶ “WHO Coronavirus Disease (COVID-19) Dashboard.” Data last updated: May 16, 2020, 6:45 p.m. CEST World Health Organization, https://covid19.who.int. Accessed on May 17, 2020.

Buy it Back (Empirical Data Analysis)

Company (Period)	Nature of Business	Amount spent on Buyback 1	Number of Shares bought back 2	% of Shares bought back out of Total Paid-up Capital	Average Buyback Price per share 3 = 1/2	Stock Price per share during period (High / Low)	Dividend declared per share since buyback 4	Reduction in Dividend on repurchased shares 5 = 2 * 4	Stock Price on April 29, 2020 6	Change in Stock Price per share 7 = 6 - 3	Change in Stock Price total 8 = 2 * 7	Buyback ROI 9 = (5+8)/1	Lowest Price since COVID-19 10
Apple Inc. (Fiscal year ended on September 28, 2019)	Design, manufacture and marketing of smartphones, computers, tablets, wearables and accessories, and sale of related services	US$67.101 billion	345.205 million	7.26%	US$194.38	High: US$233.47 Low: US$142.00	US$1.54	US$531.62 million	US$287.73	US$93.35	US$32.22 billion	[US$531.62 million + US$32.22 billion]/ US$67.101 billion = US$32.75 billion/ US$67.101 billion = 48.81%	US$224.37
Berkshire Hathaway Inc. (Fiscal year ended on December 31, 2019)	Insurance, freight rail transportation, utility, energy and investments	US$4.85 billion	16,148.94 equivalent Class A common stock	0.98%	US$3,00,329.3095 Class A common stock	High: US$3,42,250 Class A Low: US$2,86,650 Class A	-	-	US$284,749.00	(US$15,580.3095)	(US$0.25) billion	(US$0.25) billion/ US$4.85 billion = (5.19%)	US$240,000 Class A common stock
LVMH Moët Hennessy - Louis Vuitton (Fiscal year ended on December 31, 2019)	Fashion and leather goods, perfumes and cosmetics, watches, jewellery, wines and spirits	€213.3299 million	0.6147 million	0.12%	€347.04	High: €419.50 Low: €243.65	€2.60	€0.5733 million*	€359.80	€12.76	€2.8136 million*	(€0.5733 million* + €2.8136 million*)/€213.3299 million = 1.59%	€287.95
Tata Consultancy Services Ltd. (Financial Year 2018-2019)	Computer programming, consultancy and related activities	Rs. 16,000 crores	7.62 crores	1.99%	Rs. 2,100	High: Rs. 2,255.55 Low: Rs. 1,454.83**	Rs. 99	Rs. 754.29 crores	Rs. 1,905.20	(Rs. 194.80)	(Rs. 1,484.19) crores	[Rs. 754.29 crores + (Rs. 1,484.19) crores]/Rs. 16,000 crores = (Rs. 729.90) crores/Rs. 16,000 crores = (4.56%)	Rs. 1,636.10

* Reduction in Dividend and Change in Stock Price since the buyback up to April 29, 2020 has been considered on the net purchase (gross purchases less sales) of 0.2205 million i.e., 220,500 shares bought back in the fiscal year ended on December 31, 2019.
** adjusted for bonus 1:1; price from May 31, 2018 was ex-bonus.
Source: Company Form 10-K, Annual Reports, Universal Registration Document and website.