Put Options with a Difference

For last couple of years, buy backs have become extremely common. We see this extremely prevalent not just in India but across the markets in the world. So, what is a buy –back? Simply speaking, it is the company repurchasing its own shares from the existing shareholders. Then, why would a company undertake a buy back? There are multiple reasons for that.

Buyback typically leads to improved Earnings Per Shares (EPS). For the same amount of profit, the EPS will be higher, because the denominator has reduced. Another reason would be excess funds/reserves which are lying with the company. The reason for having these excess funds can be organic which the company has built through its profits over the years or it can be inorganic, created by sell of some assets. If the company sees no requirement of the funds to finance its growth or does not see any further growth opportunities, they tend to distribute this money via buy-back.

So, how can one gain out of this? When a company announces a buy-back it clearly states all the details. The number of shares, price and total value of the buy-back are defined. Further, what part is reserved for which category of holders is also mentioned. The categories here are Retail (holding less than 2 lakhs value worth) and non – retail, consisting of local financial institutions, foreign financial institutions, corporates, individuals holding more than 2 lakhs value worth.

As a retail investor, with 15% of the total offer blocked for them, the possibility of higher acceptance is generally very high. For, instance in the recent announced by Wipro on its buy back, 3.56 crore shares are reserved for retail, while the total holding in this category is close to 12.93 crore shares, this indicates a possible acceptance of ~27%. So, in this context if one is holding 40 shares of Wipro (value being less than 2 lakhs). Atleast, 11 shares will be accepted in the buy back at 400.

The acceptance will be a function of how many more shareholders get added to this by the time the buy-back date arrives. This will reduce the acceptance. While on the positive side lot of existing holders will not tender in the buy-back thus increasing the acceptance ratio.

Around these calculations on thing is for sure, that the holders get access to an In-The-Money (ITM) Put option at zero cost. As existing holders or participants who added the stock after the buy-back was announced you know that one part of the holding will be sold at a decent premium. That selling price and quantum is fixed so it is easy to keep a track of it.

An ITM put option is the costliest one is value terms, because one has to pay of the intrinsic value as well. Here, that cost is taken care of. One can build multiple strategies around the remaining holding which would not be accepted in the tendering.

Clearly, a buy back is like having access to a zero cost ITM Put option.

Happy Trading!!!

Cheers.