Share buybacks by listed companies is a bad idea

Share buyback programmes, except in the rarest of rare circumstances, are neither good for the company nor make for good governance.

Freshworks recently made headlines by simultaneously laying off 660 of its employees globally and announcing a $400 million share buyback programme. Every company has the prerogative to run a lean and efficient organisation and the freedom to optimise (read ‘downsize’) its headcount. Companies that choose to exercise this freedom with wanton disregard for employees should be prepared for them turning callous and vengeful when it comes to protecting the company’s interests in terms of business, IP, confidential information, or even just walking away without notice. This article is not about layoffs versus loyalty, but about the share buyback programme.

I have always viewed share buyback programmes with suspicion. Share buyback programmes, except in the rarest of rare circumstances, are neither good for the company nor make for good governance.

A growing cash surplus is usually indicative of two things: a) the company has a portfolio of products that customers love and b) the company is running out of new ideas to invest in. It is perfectly alright, and even natural, for companies to run out of new ideas at some point in their lifecycle. Not every company can continually reinvent itself, and most companies end up being a victim of the eternal cycle of creative destruction. If not for large companies running out of new ideas, there would be no place for new start-ups to emerge and flourish.

Typically, excess cash, in the absence of new ideas, results in companies either indulging in brash and non-accretive M&A or venturing into new lines of business that are outside of what would normally be considered a strategic fit. An equally bad option available to listed companies is to announce a grand buyback programme, making it sound like a smart move.

Nothing tops business performance 

Companies with debt on their balance sheets, especially those with a low debt-equity ratio, argue that increased leverage following a buyback would boost share price. But that is not a great way to boost the share price. The only way to boost share price is through business performance. And what logic do debt-free companies have when they announce buyback programmes!

Even if financial engineering was an acceptable way of creating shareholder value, the share price will get an uplift only if the buyback results in an uplift on the EPS on the outstanding shares after buyback. Let’s take an example to illustrate the point.

Take a debt-free company. Assume the company has 50 thousand shares on its balance sheet and has earnings (profit) of $3 million. Therefore, the EPS is $60. Let’s assume that the surplus cash on the balance sheet is earning a return of 10%. If the company’s share price is $1000 and they announce a $12 million buyback programme at a price of $1,200 per share (a 20% premium over the prevailing market price), let’s see what happens to the EPS for the balance 40 thousand shares after the buyback. The amount the company spends on buyback is $12 million. This loss of cash from the balance sheet results in a reduction in earnings in the subsequent period of $1.2 million (the 10% that the surplus cash earned) and hence the EPS for the remaining 40 thousand shares drops from $60 to $45! So, imagine the plight of shareholders who chose not to tender their shares for sale in the buyback programme!

One can’t help wondering as to who benefits from such buyback programmes because the quota for retail investors in such buyback programmes is a fraction of the total buyback. Why should any large shareholder lobby exert pressure on the company to buy back shares when there is a market where anyone can sell their holding?

Are there vested interests?

The SEC found that ‘executives are using buybacks to cash out their compensation at investor expense, and in fact, twice as many companies have insiders selling in the eight days after a buyback announcement as sell on an ordinary day.’

The job of a company’s leadership is to run a profitable and predictable business that delivers sustainable growth, and in the process deliver shareholder returns. Succumbing to shareholder lobbies to buy back shares at a premium to the market price is not a sign of good leadership.

A cash-rich listed company, with limited avenues for meaningfully deploying the surplus cash, can pay out a special dividend to all the shareholders. This is a clean option that does not discriminate between different shareholders.

However, private companies that are sitting on more cash than they need to fuel sustainable growth can, if they wish to, use a part of the cash to buy out impatient early-stage investors. But even in these situations, the buyback price should be set at a level that is beneficial to the patient shareholders, which means it should be at a reasonable discount to the existing fair market value.

In conclusion, listed companies buying back their own shares is a bad idea from every point of view and is a red flag.