By Ruma Dubey

Warren Buffett’s company, Berkshire has not declared a single dividend since 1960 but yet shareholders flock to hold shares in this company? Apart from the fact that it is a Warren Buffett company, he has helped created wealth for his investors – through consistent buyback of his own shares.

And while Buffett discovered buyback way back in 1962, we in India remained obsessed with dividends. Any high dividend paying company, it used to be MNCs and Bajaj Auto and ITC in those olden days. Currently MNCs remain but more desi and PSUs have also joined the list.

Arun Jaitley put an end to this dividend party in the Budget of FY17. He announced in Feb’16 that effective 1^st April’16, a 10% tax will be levied on dividend income exceeding Rs.10 lakh in the hands of the recipient. There is already a Dividend Distribution Tax (DDT) at 20.36% but this is to be paid by the company; the dividend was exempt in the hands of the shareholder. That is the reason why we saw companies rushing ahead with very generous interim and final dividends before end of FY16. The dividend party is over but a new theme seems to have taken off – buyback. Cash-rich companies are now announcing buybacks – company buys back its own shares from the market thereby reducing floating stock, increasing promoter stake, reducing its equity capital (outstanding shares) and thus improving EPS ahead.

Buyback is done either through the tender route or from the open market. In the tender route, the company sends a mailer to each and every shareholder , telling them about its offer to buy back their shares at a stipulated price by a certain near-term date. Shareholders who find the price to be good, ‘tender’ their shares to the company. On the other hand, in open market, as the name suggests, company buys back shares from the market, not even knowing who the seller is.

Wipro was the first company to announce a buyback – spending Rs.2500 crore to buyback shares at Rs.625/share. And since 1^st April many companies have announced buyback, prominent amongst them being the recent Sun Pharma and prior to that Novartis, Dr.Reddys, Nalco, Bharti Airtel, Excel Inds, ADF Foods, Jagran Prakashan, Bharti Infratel. In fact FY16 was a record of sorts as far as buyback was concerned – as per Prime Data, there were 15 buyback offers garnering a total of Rs.1713 crore v/s Rs.1909 crore in FY15 – the lowest in seven years. We see a new record of sorts being set for buyback in current fiscal of FY17.

So is this buyback a good deal? Better than dividend? From a wealth creation point of view, yes, buyback leaves you with more. Let us consider a hypothetical example. Let’s assume name of the company as Vava Voom Ltd (VVL), listed on the BSE and NSE. VVL has an equity of 50 crore shares and is trading at Rs.20/share, giving it a market capitalization of Rs.1000 crore. In FY17, it has a revenue of Rs.10,000 crore and net profit of Rs.100 crore. EPS is at Rs.2 and PE is at 10. And in FY17, being its 100^th year of existence, the company gives out its entire net profit, Rs.100 crore to the shareholders.

If this Rs.100 crore was given out as special dividend, the 50 crore shares would each earn Rs.2/share. Suppose Mr.Tinku owns 1000 shares, he will get Rs.2000 as special dividend. As this is nowhere near Rs.10 lakh, this income will be tax free for Mr.Tinku. But for one promoter, who owns 6 crore shares, it would mean dividend income of Rs.12 lakh. Thus he will pay a tax of Rs.1,20,000, getting an after tax income of Rs.10.80 lakh.

And now suppose Rs.100 crore was used by the company to buyback shares. This buyback will happen over months and if from the open market, at different prices. So let us assume that VVL buys back 5 crore shares at Rs.20/share. This means that its outstanding equity or floating stock has reduced from 50 crore to 45 crore shares. Due to the reduced floating stock, the worth of Rs.20/share automatically goes up. Mr.Tinku will anyway remain a gainer but the promoter, if he holds this bought stock for more than one year, will save on capital gains tax. So how does he gain? In FY18, let’s assume there is no change in earnings and net profit comes in at Rs.100 core. The EPS will now be Rs.2.22, up from Rs.2 without adding any profits or growth. And if the PE also remains the same at 10, it means, stock price has gone up to Rs.22.22.

Thus the promoter is the big gainer – without doing anything but merely buying back, he manages to improve the EPS of the company and increase his stake. Mr.Tinku is happy that EPS is up but he does not really gain anything if he does not participate in the buyback. But if he sells his share, assuming he purchased it at Rs.20, his gain will be Rs.2220. If this is being sold within a year of his purchase, he will attract capital gains tax of 15%, meaning his post tax earning will be Rs.1887.

Buyback is a great tool for the promoters to improve their wealth – where CEOs and management pay is linked to stocks – stock options; thus buyback is a good way to boost their own income. Also by increasing the demand for a company’s shares, open-market buybacks automatically lift its stock price, even if only temporarily, and can enable the company to hit quarterly EPS targets.

More importantly, cash which can be used for creating growth, either through acquisition or by ploughing back to fund capex plans, is now being diverted to buy back shares. How is this growth accretive?

Buyback to some extent is good but consistent buybacks do not add value to the company. Extremely cash-rich companies like Reliance can afford to do that but not when cash is low and buyback is done using debt.

As we always say, everything in moderation is good – even dividend and buyback.