Wednesday, November 6, 2013

Are Share Buybacks Really Meaningful?

After my article on stock splits, I believe I should discuss my thoughts on share buybacks, another important topic in corporate finance. I will write about other topics such as dividend payout policy, M&A, executive compensation etc in the future.

What are Share Buybacks?

Share buybacks, also know as share repurchases, are methods of returning cash back to shareholders. The net effect of repurchasing shares will result in less shares outstanding, which increase the ownership of shareholders who decide to maintain their stake. Companies usually purchase their shares on the open-market, although a tender offer can also be used. In Canada, an open market share buyback program is called Normal Course Issuer Bid (NCIB).

Rationale Behind Share Repurchases: Returning Free Cash Flow

Basically there are 3 main uses of free cash flow (often defined as operating cash flow minus capital expenditures): (1) pay down debt (2) make an acquisition (3) return it back to shareholders via dividends or share buybacks. Most executives hate option 1 because they want to maintain an "optimal structure" of debt and equity. In my own opinion,  it may be prudent to reduce debt levels when excessive free cash flow exists since high cash levels usually build near the height of an economic boom, which implies a recession may be on the horizon. Reducing debt levels in good times prepares the company for bad times such as a recession or economic slowdown. Also, it leaves excessive capacity to take on more debt in recessionary times when interest rates are much lower. Option 2 was popular but CEOs are now more cautions when it comes to acquisitions especially after the disastrous outcomes of serial acquirers like Tyco, Worldcom, or Citigroup. Accounting treatment is also less favourable with FASB and IASB abolishing the pooling of interests method. Option 3 is the most commonly used method of returning free cash flow and most executives prefer stock repurchases just because it is "tax-efficient" over dividends. Although the argument is valid, purchasing shares above intrinsic value is value destroying (see example below) despite being a little tax efficient  If the shares do trade above intrinsic value and the company has excessive cash, it should consider boosting its dividend instead.

Example:

Stock X is trading at $150, has 100 million shares outstanding, and earns $500 million a year. This implies a market capitalization of $15 billion and EPS of $5. Let's assume that the true intrinsic value (hidden from the public but can be roughly estimated by the intelligent investor) is only $10 billion or $100 per share, which implies the stock is 50% overvalued. 

If the company decides to repurchase 5% of its outstanding shares (5 million shares) at $150 and still makes $500 million a year, EPS would increase from $5 to $5.26, a magical 5.2% increase. However, if the share price corrects to the actual $10 billion (in the long run, the market is a weighing machine and will be efficient) , the high purchases made at $150 are clearly value destroying. If the company did not conduct the share repurchase, intrinsic value would still be $100 per share (10 billion value divided by 100 million shares). If they did the share repurchase, they would destroy $250 million of value by buying shares for $750 million when intrinsic value of those shares is only $500 million. Thus, intrinsic value of the company after the repurchase is 9.25 billion or $97.37 per share. ([$10 billion - 0.75 billion]/ 95 million shares). Well congratulations shareholders of company X, it just destroyed $2.63 of value on a per share basis. The company may had good intentions, such as returning cash to shareholders, but buying back shares above intrinsic value is dumb. Many would argue against me by stating there is no exact method of determining the intrinsic value. Nonetheless, I believe experienced managers who is familiar with industry trends and the company's financials should have a rough idea on the company's intrinsic value. Academic studies have shown that following the insiders (after they disclose a purchase or sale) can earn abnormal returns. 

If the shares was 300% overvalued, this transaction would destroy over $11.50 of value on a per share basis. The prior examples are typical in the real world. Why? This is because corporations usually have large cash hoards in boom times or just before a recession hits, which also corresponds to when their share prices are often overvalued in the market. Many corporate executives are often pressured to return cash to shareholders and believe buybacks are the most efficient method. 

Rationale Behind Share Repurchases: Growing EPS or Offset Share Dilution 

Short term earnings accretion get the attention of analysts and the financial press, but prudent investors should look for underlying value creation, not earnings accretion. As the example above shows, there is earnings accretion with EPS growing 5.2%. However, the actual intrinsic value of the business, on a per share basis, is lower as a result of repurchasing shares above intrinsic value. 

Another common argument is that companies often issue stock options and exercising those options could dilute existing common shareholders. The problem of offsetting that dilution with share repurchases is that buying shares above intrinsic value would destroy more value than merely letting its shares outstanding increase. Let's go back to the prior example. If there is 5 million of options, the shares outstanding would increase to 105 million and EPS decreases to $4.76. Most executives doesn't like that lower EPS so they decide to repurchase shares. If the company doesn't do anything, intrinsic value reduces to $95.24 ($10 billion/ 105 million shares) or $4.76 lower. If the company decides to repurchases 5 million shares at $150 (greater than $100 intrinsic value) to offset the 5 million share dilution, intrinsic value is reduced to $92.50  ([10 billion - 750 million] / 100 million shares)  or $7.50 lower. Clearly $95.24 > $92.50, so repurchasing shares when the shares are overvalued is a dumb idea. Buying loonies for tonnies is plain silly (For non-Canadian readers, loonies = $1 while tonnies = $2) 


Share Buyback Lesson from the Oracle of Omaha:

We pay so much tuition to learn finance in University but the best source, Buffett's Annual Letters to shareholders, is available on the Berkshire Hathway's site for free. Regarding share buybacks, Buffett's clearly explained his position in his 2011 Annual Letter (see the section on "Share Repurchases" on page 6-7). Here is a quote taken from the letter:

"Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated"

Buffett explains how CEOs, even the honest and hardworking ones, fail the second test miserably. A CEO may think his company's share price is cheap no matter what price it is selling at. Even the honest executive is led to believe that returning excessive free cash flow is necessary. Buffett argues that this is not true. There is no point of a share repurchase UNLESS the you can repurchase the shares below intrinsic value, hopefully conservatively calculated as Buffett suggests. Notice Buffett never mentions earnings accretion or returning excessive free cash flow as criteria when deciding a share repurchase.

Here is another interesting thought from Buffett: "When Berkshire buys stock in a company that is repurchasing shares, we hope for two events: First, we have the normal hope that earnings of the business will increase at a good clip for a long time to come; and second, we also hope that the stock UNDERPERFORMS in the market for a long time as well ." 


Wait, what? Did Buffett just say he hopes the share price would underperform the market for a long time? This is not a typo. The logic is a simple one, but often not well understood. If the share price underperforms, the company can purchase more shares and the remaining shareholders would own more of the company (and receive more share of the company's long term earnings as well). If IBM's share price remains at $200 for the next 5 years, Berkshire's 5.5% stake in the company would indirectly increase to 7% through the ~$50 billion share buyback program. But if IBM averaged $300 in the same period, then Berkshire's stake would only increase to 6.5%. The 0.5% may seem small but it makes a big difference in the long run. If net income is $20 billion for IBM per year, then Berkshire will get an additional $100 million share of that income. IBM's stock price is in fact languishing right now as expected and sell-side analysts are cutting their price targets like crazy. While analysts criticize IBM for poor share performance, Buffett must love the lower share price right now. It's hard to think long term but let's not forget the moral behind the turquoise vs. hare story. 


If the company is pursuing a large buyback program, shareholders should cheer when the stock price languishes. As Buffett says: "The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon. Emotions, however, too often complicate the matter: Most people, including those who will be net buyers in the future, take comfort in seeing stock prices advance. These shareholders resemble a commuter who rejoices after the price of gas increases, simply because his tank contains a day’s supply." Very well said Mr.Buffett, I thank you for sharing this point many people miss. 


Conclusion:

To answer the question in the title, share buybacks is definitely meaningful method of returning capital to shareholder only if the company can repurchase shares under intrinsic value, conservatively calculated. Investors should be cautious when CEOs announce buybacks because their intent is to offset share dilution or increase EPS growth. If CEOs announce buybacks because they want to return free cash flow, carefully assess the company's intrinsic value. If the company's shares are trading below intrinsic value, you should applaud the move and give a big thumbs up. If it is not (especially if it is significantly above your estimate of intrinsic value), you should  re-consider your investment thesis in the company. No matter how great a business may be, investors should not invest in the company if the CEO makes poor capital allocation decisions because those decisions can lead to a lot of value destruction. (An exception would a net-net special situation but I'll again save this topic for next time)

2 comments:

  1. Great article Kenny. The examples are well understood and the explanations succinct and to the point.

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  2. Very impressive and well written blog on market guiding the investors with important information. Many of the investor will be happy to read your blog and earn huge profits in there investment.

    ReplyDelete