Why RIL and Godrej Consumer products are buying back their stock at current market prices,do they think their stock is much undervalued now?
Buyback tricky for small trader
Evaluating benefits best left to pros
By Jeff Brown
Knight Ridder
1/83/8
Here's a dazzling figure: In the first quarter of the year, companies in the Standard & Poor's 500 index nearly doubled their spending on share buybacks to a record $82 billion from about $43 billion in the first quarter of 2004.
Is this good news or bad? In many cases, if not most, it's probably not the good news these companies claim it is.
In a buyback, a company uses cash to buy its own shares on the open market, just like you would.
If a company bought back 50 of its 100 shares, each remaining share would represent 2 percent ownership in the company instead of 1 percent. Assuming the company had $10 in earnings to be distributed as dividends, each share would get 20 cents instead of 10 cents. Doubling earnings per share theoretically would cause the share price to double as well.
But it doesn't always work this way. Often, there is no reduction in shares outstanding; the company buys shares to offset the distribution of new shares through stock options exercised by executives and other employees. Options allow their owners to buy shares at a set price within a given period, usually 10 years. They can provide risk-free profits if the share price rises.
In these cases, buybacks do nothing for shareholders, unless you assume the options make people work harder. Cash used this way ends up in the pockets of executives and employees rather than shareholders.
S&P found such "options covering" to be the most common goal of buybacks. Indeed, 36 percent of the first quarter's buybacks reduced shares outstanding, and 56 percent were part of programs that left more shares in circulation, reducing each share's value.
Even if a buyback does reduce shares outstanding, investors should question whether this is the best use for company cash.
Why not use it for research and development or to expand? Using cash for a buyback means the company can't think of anything better to do with it, and that can be a cause for worry.
Why not hand the money to shareholders through dividends, allowing them to decide how to use it?
There used to be a tax reason. Many investors did not want dividends, which were taxed at much higher rates than capital gains realized when a stock was sold for more than what had been paid.
But dividends and capital gains are now taxed at the same rate - 15 percent. Hence, the only tax advantage to buybacks is, assuming they boost the share price, the tax bill on that gain isn't due until the shares are sold, but dividends are taxed the year they are received.
Companies announcing buybacks typically claim their shares are a good investment because they are trading at bargain prices. But investors should take this with a grain of salt.
After all, when's the last time you heard a corporate executive declare that his stock price was too high? If the goal is to invest surplus cash in a good stock, are the company's shares really the best out there?
It's as if you asked your stockbroker to find you good investments and he repeatedly recommended shares in his own company. Smell funny?
Most small investors will have a tough time judging whether a buyback makes sense. I'd start by asking whether you'd rather get that cash through a special dividend.
If the buyback is connected to an options program, look at who's getting the options. Are they going to employees at all levels, encouraging everyone to do good work? Or are they simply fattening the obscene pay of a few executives?
Companies generally put buyback proposals to shareholders at annual meetings. Use that chance to vote no if the company hasn't made a compelling case. If this kind of evaluation seems too difficult, do your stock investing through mutual funds, letting the pros figure it out.
posted by jagadish @ 6:38 AM
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