Buybacks: Beware of the risks

Tue, 6 Aug Pre-Open

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Capital allocation is one of the key criteria to judge management efficiency. As long as the company is able to increase returns on capital employed, it is best to keep reinvesting in its own business. But if it is unable to find return accretive avenues then it should ideally return the excess cash to its shareholders. One way in which it could do so is through the purchase of its own shares from the open market, also known as stock buyback. Buyback are especially popular in times when stock markets do not performing well. They are often seen as a positive sign that the management is confident about the future prospects of the company.

There are also fresh investors who get into frenzy to buy the stocks as soon as a buy back announcement is made. Since mostly companies announce a maximum buyback price that is higher than the current market price, the lure of making easy gains is hard to ignore. But does it really make sense to base your investment decisions just on the basis of such announcements? Well, we don't think so.

As an article in Economic Times elaborates, there are ample cases when buyback offers have not been followed by an increase in the stock price subsequently. Infact, in some cases, the stock prices have actually declined post buy back. So what should investors do in such cases?

The answer lies in a thorough fundamental research and knowing the motive behind buyback.

Motives behind buybacks

The motives behind the buybacks could be many. Right from creating value for the shareholders, avoiding a hostile takeover, delisting or to manipulating the market. Through buyback, a company can use surplus cash to buy its own stock if the management feels that the same is undervalued. Post buyback, this is likely to lead to better metrics like higher earnings per share. But if the company is cash constrained (not enough cash post making provisions for operational and liquidity needs) or if the stock is not cheap, then one needs to dig further. It could be the case the management is using this tool just to create an impression of better earnings per share to manipulate market valuations.

What should shareholders do?

To avoid falling for such traps, one must focus on the fundamentals of the company. Once you have an idea of the fair price, the decision making is relatively easy. In case the buyback price is higher than fair price, the residual value (share price post buyback) is likely to be lower. Hence, it makes sense to get out of the stock.

On the other hand, if buyback price is lower than the fair value, it makes sense to retain the stock. Besides fundamentals, one should also think over the motives and details of buyback. If a company with surplus cash is buying its own shares at times when stock price is undervalued, it means that management is focused towards creating value. However, at times company may buy shares to make some financial metrics like per share earnings look better. One should be especially cautious when buy back announcement comes just before earnings announcements.

Size matters

The buyback announcements often lead to speculations and higher valuations on a likely increase in earnings per share (on lower outstanding shares). However, not many people bother to assess the gains. There are cases when the size of buyback is not big enough to make any material difference in the EPS post buyback. So it is better to do your own calculations to avoid negative surprises.

Avoid the traps

There have been quite a few instances when investors have burnt hands in cases where actual buy back has not followed the announcement. In these cases, the share prices have soared merely on speculations, only to come down later. It can be a huge risk to get carried away and base investment decisions just on such announcements. One must keep in mind that there is no substitute for fundamental research on the company. Further, being aware of the details and the motives of the buyback can help one follow the right course of action.