Buyback can be a great opportunity to a make decent profit in a short period. But not all buybacks are worth to participate. Let us try to understand how you can profit from the share buyback of a company.
What is buyback
When a company buys back its own shares its called buy back. When the buy back is complete the number of shares outstanding reduces by the amount the shares are bought back. The cash on the blance sheet of the company also goes down because the company is buying back the shares by using that cash. To encourage the existing shareholders to surrender their shares in the buyback, the buyback price is usually set 10-30% higher than the current market price. That gives a good opportunity to make the profit by surrendering the shares at a higher price and even you don’t want to surrender you can still make good trading gains.
When not to participate in the buyback
Many times the share price of a company falls due to some serious problems in the company. In such kind of situations, the managment sometimes announces the buy back to improve the sentiments of the investors towards the company. I prefer to avoid the buy backs of the company who are in trouble.
Also when the buyback price is less than 20% above the current market price then also I prefer to avoid buyback.
How to profit from the buyback
To understand whether buyback trade will be profitable for you or not you have to first understand the acceptance ratio. Acceptence ratio tells how many of your shares are likely to be accepted in case you tender your shares. When the company announces the buy back plan, it also announced how many shares from the small category share holders will be accepted. Usually, 15-20% are reserved for the small shareholders.
You need to check the shareholding distribution to know what could be the possible acceptance ratio.
Below is the share holding pattern of a company that announced buy back of 92 lakh shares, out of which 15% that is 13.8 lakh shares were reserved for the small shareholders.
If you look at the shareholding distrubtion here, people holding 1 to 5000 shares are considered small shareholders and they are holding 12.8 lakh shares, since 13.8 lakh shares buy back is reserved for them there will be 100% acceptence from the retail shareholders.
But this won’t be the case by the time of record date for buy back. As by knowing about the buy back more people will buy it before the record date and this will take the number of small shareholdres to a higher level and the acceptence ratio will get reduced. This buying from the small shareholder will result in the increase in the share price also. So even if you don’t plant to surrender your shares this can be a good trading opportunity.
Your effective cost of buying
Lets say the shares of a company are trading at 100 Rs in the market and it has announced buy back at 130 Rs. If you buy 100 shares of it at the current market price of 100 Rs. There are different scenarios possible
In the case of 100% acceptance, you will make a profit of 30% by buying at the current market price.
In case of 70% acceptance your 70 shares will be accepted at 130, this will give a cashflow of 9100 Rs and you will be left with 30 shares for which your effective outflow has been 900 Rs. Which makes your cost of 30 shares 30 Rs
In case of 50% acceptance your 50 shares will be accepted at 130, this will give a cashflow of 6500 Rs and you will be left with 50 shares for which your effective outflow has been 3500 Rs. Which makes the cost of 30 shares 70 Rs
In case of 30% acceptance your 30 shares will be accepted at 130, this will give a cashflow of 3900 Rs and you will be left with 70 shares for which your effective outflow has been 6100 Rs. Which makes your cost of 70 shares 87 Rs
In case of 10% acceptance your 10 shares will be accepted at 130, this will give a cashflow of 1300 Rs and you will be left with 90 shares for which your effective outflow has been 8700 Rs. Which makes your cost of 90 shares 97 Rs
So you can see here in case 30-70% acceptance your effective buying cost will 13-70% lower than the current market price and you can make a decent profit.
Below the acceptance ratio of 30%, the profit won’t be decent.
You need to keep a watch on the latest shareholding distribution pattern, to understand what can be the acceptance ratio. If you see that number of small shareholders has increased by a good number and acceptance ratio is not that attractive it is better to sell the shares few days before the record date in some decent trading gains.
Abhishek is an Engineer MBA in Finance and Certified Research Analyst. He is an active trader and investor in the stock market since 20010. Follower of the philosophies of Warren Buffet and Peter Lynch in investing and trend following in trading.