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The Buyback Conundrum


  • Buybacks should increase shareholder value, but that’s not always the case.
  • From a book value perspective most companies are destroying value.
  • From a return on investment perspective the logic behind buybacks is open for discussion.

Introduction

The goal of investing is to enjoy stock price appreciation and dividends, but there is another method for achieving interesting returns: buybacks. With stock buybacks, a company buys its own stocks on the open market. As a public company cannot fully own itself, the purchased stocks lower the number of outstanding stocks and increase the relative ownership of the remaining stockholders. In other words, the company is using its cash to invest in itself.

If a company invests in itself, what has to be calculated—and often is not—is the return on that investment. This article analyzes the mechanics and motivation behind buyback returns and the real effects on investor returns.

The Motivation Behind Buybacks

Buybacks are usually promoted by management as the best use of capital at a specific moment. Buybacks improve financial ratios, and ratios are what analysts focus on. By lowering the number of shares outstanding, earnings per share (EPS) increases, and by spending cash, the company has less assets and equity and therefore return on assets (ROA) and return on equity (ROE) increase.

Another thing covered up by buybacks is dilution. Generous employee stock option plans create dilution, and no regular investor likes that. A good example of dilution coverage is Cisco Systems Inc. (NASDAQ: CSCO). The company spent $4.2 billion on repurchases in 2015 by buying 155 million shares at an average price of $27.22. 155 million shares on a total amount of 5.09 billion shares outstanding in 2014 would imply a nice 3.03% return to shareholders from buyback activity. But the total number of shares outstanding at the end of 2015 was not 4.94 billion, but 5.06. Thus, CSCO lowered the number of shares outstanding by a mere 38 million shares and not by 155 million like they proudly announced in their annual report due to dilution.

The Logic Behind Buybacks

If the stock of a company is really undervalued, buybacks make sense, but if the price is above intrinsic value the buybacks are questionable, or as Warren Buffett said:

In repurchase decisions, price is all-important. Value is destroyed when purchases are made above intrinsic value.

Berkshire Hathaway (NYSE: BRK) is known to buy back stocks but maximally pay a premium of 20% on book value.

1 price to book berkshire

Figure 1: Berkshire buyback activity and threshold. Source: Bloomberg.

The above 20% premium that Buffett is willing to pay does not mean he agrees to paying a premium, it relates to that fact that many of Berkshire’s investments are accounted at cost and therefore not properly reflected in the balance sheet. Think of See’s Candies, bought in 1972 for $25 million.

According to the chart below, Buffett would not agree with the principle that any buyback is a good buyback. The S&P 500 price to book value is currently 2.82 that implies an average 182% premium on buybacks.

2 sp 500 book value

Figure 2: S&P 500 Price to book value from 2000 to 2016. Source: multpl.

The question now is: are buybacks creating or destroying value? The lowest S&P 500 price to book value was recorded in March 2009 and was 1.78. Thus, according to Buffett’s logic, the bulk of buybacks should have taken place in 2009. Of course, that is far from the truth.

3 buybacks in millions

Figure 3: Quarterly share repurchases ($M) and number of companies repurchasing shares. Source: Factset.

In Q1 2009, buybacks were at their lowest with only $30 billion of stocks being repurchased. Not surprisingly buyback activity is the highest at market peaks, as evidenced by Q4 2007 when $180 billion was spent. This shows that management is not keen on following Buffett’s logic.

According to Bloomberg, a strong factor for buyback activities is that CEOs’ paychecks are based on EPS metrics (39% of it) and by buying back shares, a CEO can increase his paycheck even if sales are not growing. The focus on increasing EPS through buybacks limits the use of available cash for long term investments. Currently S&P 500 buybacks are 70% of the net income companies make, consequently only 30% of the net income is used for growth or dividends.

4 buyback and net income

Figure 4: Trailing buybacks to net income for the S&P 500. Source: Factset.

The current stock market situation reflects a fall in net income and an increase in share buybacks that is very similar to the situation at the end of 2007. This does not mean much as history is not a good predictor for financial markets, but it’s good to keep in mind.

How to Check if Value is Increased or Destroyed by Buybacks

There are a few things to check. A company should buy back shares only if that is the best investment possible. An investment is assessed by looking at its book value if you want to listen to Buffett, or by looking at the current return if you want to be more trendy. With the first option, if the company is buying back shares and paying more than book value, it is destroying shareholder value because it would be better to use that money to grow the business as the business itself is more valuable than its book value. For the second option, if the company is buying back shares and the return on those shares is lower than the company’s cost of capital, the company should be better off if it would pay of some debt.

The return on the stock is easily calculated by using the PE ratio. 100 divided by the PE ratio gives the investor’s return on the stock. For example, Microsoft (NASDAQ: MSFT) bought back stocks for $17 billion in the last 4 quarters. It’s PE ratio is 40.1 that implies a 2.5% return from MSFT’s stock. MSFT’s interest expense on its long term debt is 2.8% which adjusted by MSFT’s tax expense of 30% would be 2%, thus below the 2.5% threshold. On a book value basis, MSFT is destroying value because it is paying $50 for something that is worth $9, and on a return on investment basis, the shareholder creation/destruction dilemma can be left for further discussion.

Conclusion

The use of financial engineering to achieve growth could also mean that a company is at the top of its business cycle and there are no better investments than buying its own stocks.

The mania of buying back stocks resembles picking low hanging fruit. By using financial engineering management, a company can improve the required ratios and increase its remuneration. Such behavior leads to a huge and not calculable cost: the opportunity cost. A company could use that cash to do acquisitions or to invest in R&D, and who knows what good might come out of that.

Every investor should individually assess each of their portfolio components and see if the management is creating or destroying value with buybacks.

 

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