A Look at Stock Buybacks
(Chris Wood filling in for David Galland)
Stock buybacks have been in the news a lot lately. Sitting on piles of cash and too nervous to invest in new workers or plant and equipment, many companies have started to deploy their cash reserves to buy back their own stock. So far this year, according to stock market research firm Birinyi Associates, firms have announced they will purchase $273 billion of their own shares, more than five times as much compared to this time last year.
Which begs the question, are these buybacks an optimal allocation of capital benefiting investors, or should companies be doing something else with their cash?
If you’re unfamiliar with stock buybacks, or share repurchases, as they are also called, they’re just another way for management to boost returns for shareholders in addition to stock price appreciation and dividends, or so the story goes. Theoretically, by increasing earnings per share via a share repurchase, Wall Street will reward the stock with a higher price.
The thinking goes like this: Let’s say Company X has earnings per share (EPS) of $2 and is currently trading for $35. That’s a price-to-earnings ratio (P/E ratio, also called a multiple) of 17.5. Now management at Company X buys back enough of the stock to boost EPS to $3. If nothing has changed at the company, except fewer shares outstanding and a higher EPS, Wall Street should apply the same multiple of 17.5 to Company X’s earnings, which would result in a stock price of $52.50.
But does it really work like this? What’s the real-world effect of stock buybacks on price?
To get a sense of the thing and in the interest of time, I randomly picked three of the top spenders on buybacks in 2007 and compared their P/E ratio at the beginning of the year to the end of the year, to see if the billions they spent on buybacks had the desired effect. (Note: I picked 2007 because it was generally a flat year overall with little volatility that wasn’t distorted by the current crisis; so if stock buybacks generally benefit investors, the effect should be visible in 2007). Here’s what I found:
- IBM spent $18.8 billion on stock buybacks in 2007, but the earnings multiple dropped from 15.7 at the beginning of the year to 14.7 at the end of the year.
- GE spent $12.4 billion on stock buybacks in 2007, but the earnings multiple dropped from 19.0 at the beginning of the year to 17.0 at the end of the year.
- Home Depot spent $10.8 billion on stock buybacks in 2007, but the earnings multiple dropped from 14.7 at the beginning of the year to 11.3 at the end of the year.
So for these three companies at least, the higher relative EPS from the stock buybacks did not result in a proportional jump in price as would be expected.
Obviously, there are more variables at play here, and I’ve simplified things, but I think we can still glean valuable insight from this small set of data – namely that the Street does not always respond favorably to stock buybacks, and the action does not always benefit investors. Often times, what we see is a percentage or two jump in price in conjunction with the announcement of a large stock buyback, but then prices settle back to previous levels in the days that follow as investors absorb what the buyback really means for the company.
As it turns out, in many cases, the real implications of the buyback are not positive. For starters, CEOs generally engage in a stock buyback at the worst possible time. Share repurchases peaked in 2007 at around $600 billion, with stocks at record highs. As stocks fell in 2008 and early 2009, so did stock buybacks. According to Standard & Poor’s, stock buybacks fell nearly 70% in the fourth quarter of 2008, despite record levels of cash in corporate coffers and much lower share prices.
Second, and more importantly, when a company repurchases its own shares, it’s saying that it has nothing better to do with its cash than employ a strategy that may or may not benefit shareholders and will do absolutely nothing to improve the firm’s long-term prospects. Personally, I’d rather see a company invest in future growth via new plant and equipment, new workers, or acquiring a new company or new technology as opposed to a stock buyback. If that’s not feasible, then I’d prefer a one-time special dividend.
In any event, let’s go back to the initial question of: are these buybacks an optimal allocation of capital benefiting investors, or should companies be doing something else with their cash? I’d say that, while each buyback has to be considered independently, based on the historical evidence and reasoning outlined above, many of these buybacks are not an optimal allocation of capital, and these companies should be exploring different ways to use their cash.
But that’s just my opinion. As an investor, it’s up to you to decide on a case-by-case basis. If the company has surplus capital and is trading below intrinsic value, a stock buyback may not be a terribly bad thing. But if the CEO and/or other insiders are actively selling their shares in conjunction with the announcement of a stock buyback (yes, this actually happens), you shouldn’t be too psyched about it.
I’ve always viewed it as stock buybacks reward the stockholder for selling the stock, dividends reward the stockholder for holding the stock; and invest accordingly.
does anyone who understands valuation think this is how buybacks create shareholder value? that makes repurchases look like nothing more than a sleight of hand magic trick. “lookie here! i just turned this worthless $200m into an extra $.75 in eps.” that only works for people who think a stock’s value is 100% derived from the earnings, without regard for the assets you own as a shareholder.
this is how i think about when a buyback helps. imagine a company with a future cash flow stream worth $1000 (the present value of the business’s future earnings), $100 of extra cash on hand, and 11 shareholders. in theory, the company is worth (not necessarily trading for) $1000 + $100 = $1100 and $100 per share. Imagine the company’s earnings were $100 for a multiple of 11x.
now assume management is trying to figure out what to do with that extra cash. they decide to buyback the shares of one of the shareholders. in scenario 1, they pay the “intrinsic value” of $100 per share. is anyone better off? now the company only has a future cash flow stream worth $1000 and 10 shares, each worth $1000 / 10 = $100. they own a higher proportion of the future cash flows, but they had to pay for them. the p/e multiple is now 10x ($1000 value / $100 earnings). i admit that the street can be kind of dumb sometimes, but do people think that everyone blindly slaps multiples on whatever eps they see?
now imagine another scenario. what if instead of paying $100 for that one share, the company paid only $80? the company still has a cash flow stream worth $1000, but it also has an extra $20 still kicking around. each remaining share is worth $1000 + $20 = $1020 / 10 shrs = $102. and there is the increase in shareholder value. and the p/e multiple is now $1020 / $100 = 10.2x.
a couple problems with this.
first, this assumes that everyone agrees on the value of the business’s future cash flows and can value them properly. my retort is that even if people don’t know what the value is, it still has a value and if management or shareholders believe they can repurchase stock for less than that, doing so can add value.
second, the market might not give the company full credit for the cash on hand, ie by valuing the cash on hand at $.50 on the $1, maybe because management has a history of wasting cash on stupid acquisitions. i don’t really have a good retort to this one. i know it’s real though.
sorry for the long post.
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