Share Buybacks
About to hit a new record?
Russia invades Ukraine, the price of oil hits record highs, inflation is raging, interest rates and bond yields are heading up and stock prices are down 10-20% in many of the world’s major markets. Time for a big stock buyback?
Well apparently so, according to this article in the WSJ, Stock Buybacks On Course for Another Record. Companies in the S&P 500 have announced plans for $238 billion in share buybacks in just the first two months of this year and Goldman Sachs estimates that the amount of completed buybacks may hit $1 trillion by the end of the year. What is driving all this feverish buyback activity?
Well, before we answer that, let’s do a bit of a recap on the subject of stock buybacks.
What are stock buybacks? Stock buybacks are exactly what the name suggests: the repurchase by a corporation of its own outstanding shares. This is typically done for cash on the open market in an announced buyback program compliant with SEC guidelines, which limit the number of shares a company can buy back in any period and cap the price which can be paid for the shares. SEC guidance also provides that companies not buy back shares during “blackout” periods around major corporate events, such as earnings releases. For an overview of the legal aspects of share buybacks, read this post on Share Buybacks from the Skadden Arps law firm.
Why do firms buyback shares? Skadden Arps summarizes the reasons well:
returning capital to shareholders in a more tax-efficient manner than declaring dividends;
signaling to the market that its shares are undervalued and thus a good investment, particularly due to current volatility;
offsetting the dilutive impact of merger and acquisition activity and exercises of employee stock options; and
reducing outstanding share count, thereby increasing earnings per share or improving other metrics based on the number of outstanding shares.
And I would add to the Skadden list one other reason that companies do buybacks rather than increase dividends: buybacks are more flexible than regular dividends. Companies are loathe to monkey around with regular dividends, taking them up and down in response to fluctuating company fortunes or market conditions. Buybacks can be turned on and off more or less at will, with no adverse impact on the regular dividend cash flow which many shareholders rely on. Of course companies could pay periodic special dividends in lieu of buybacks, but these too are perceived (rightly or wrongly) as less flexible than buybacks.
How good are companies at timing the purchase of their own shares? I have always understood the answer to be “not very”, based on empirical studies by financial economists. But the evidence may be more mixed than I had thought, as is suggested in this 2014 study from the Michigan Ross School of Business. Speculating on stock prices is not really the role of a business corporation, however, and I think even strong proponents of stock buybacks like Warren Buffett would tend to agree that market timing is difficult even for the professionals. To learn more about Buffett’s views on buybacks, read here. And for those of you who wish to learn more about Buffett’s views on corporate governance more broadly, read here.
Do share buybacks increase the value of a company’s shares? This is a complicated question, but I think the best answer is “no, at least not for the reason most people think”. If a company can buy back a large amount of its stock at a price well below intrinsic value—the present value of a company’s expected future economic profits (or future free cash flow discounted at a suitable risk-adjusted cost of capital)—then yes, the buyback will increase the intrinsic value per share. And a buyback may also increase the market price of the shares on the stock exchange at least temporarily for technical reasons (more buyers than sellers, at the moment). A buyback may even have a longer-term fundamental impact on stock price if the buyback triggers a reevaluation by investors of the future earnings potential of the corporation (up or down).
But in discussing the impact of buybacks, we should distinguish between “value” and “price”. I may pay $6 for a half-gallon of milk (organic, grass fed) but this is just the “price” of milk; the “value” of milk is a lot higher to me and a lot lower to the farmer whose cows produced it. And the same thing is true of a company’s shares, which represent a fractional interest in the ownership of the company. On any given trading day, most owners of a company’s shares do not sell and most potential investors do not buy, in part because their views of value differ significantly from the market clearing price As Warren Buffett likes to say, “price is what you pay; value is what you get”. (For more pithy Warren Buffet quotes on investing, read here.)
What about the EPS impact? Thank you for asking. Share buybacks generally increase a company’s pro forma EPS because the earnings yield on the purchased shares (E/P) is higher than the after-tax cost of funding (the interest paid on the debt or cash used to fund the buyback). This is pure accounting arithmetic. But just because EPS goes up following a buyback does not mean the intrinsic (economic) value of the shares also goes up, and certainly not by the same amount. When a company increases financial leverage, which it does when it reduces equity via a share buyback (or dividend), the riskiness of the shares goes up and with it the investors’ expected return on the shares, which in turn lowers the shares’ valuation multiple (P/E). And this reduction in the valuation multiple (increase in expected return) offsets the value impact otherwise attributable to the EPS accretion (ex tax effects). Professors Modigliani and Miller won a Nobel Prize for demonstrating this, but you don’t need a PhD (let alone a Nobel Prize) to understand their reasoning.
But contrast this explanation with what most people think happens in a buyback. If you read some of the financial press you might think that because buybacks increase EPS, share prices must also go up by the same percentage amount. This is what many journalists, companies and sell-side research analysts would have you believe, but is just ain’t so. Not in theory and not in practice, and this mistaken belief gets a lot of people in trouble. I am reminded here of the quote attributed to Mark Twain at the beginning of The Big Short: “It ain't what you don't know that gets you into trouble. It's what you know for sure that just ain't so.” Well said Mr. Clemens (or Mr. Lewis, I’m not sure.)
No one thinks that dividend announcements increase shareholder value absent some credible “signaling” of a changed economic outlook for the company, and the same thing should be true of share buybacks. Properly understood, the economic impact on shareholder value should be the same when companies return capital via dividends or buybacks, at least if we assume the same tax treatment in both cases. Dividends reduce share price by the amount of the per share dividend paid but leave the share count unchanged, and they reduce the equity value of the company by the amount of the distribution but leave shareholder value unchanged. (The shareholders receive the distribution, which just moves money from the company’s bank account into the shareholders’ bank accounts.) Buybacks also reduce equity value by the amount of the distribution, but they do so by reducing the share count while leaving the share price (and total shareholder value) unchanged.
If you want to know more about this economic value added (EVA) approach to understanding share buybacks, read this piece by McKinsey, How Share Repurchases Boost Earnings Without Improving Shareholder Returns.
Why do so many companies highlight the EPS impact of buybacks? Perhaps because their executives have forgotten what they learned in business school. But more likely they do this for the same reasons politicians spout so much utter nonsense: because they think the rest of us will believe it and we will vote accordingly. And they may be right. But let’s not play this game with important matters of corporate finance and governance. The real reason many corporate executives like buybacks is because buybacks often generate higher executive pay. Executive pay may go up following buybacks either because of compensation plans which specifically link bonuses to EPS or because boards of directors and comp committee members so often confuse accounting metrics (EPS) with shareholder value metrics (EVA). (See the McKinsey article, above.) Driving EPS growth via buybacks is a lot easier than creating real economic value through business strategy, marketing and operations, and who wants to work that hard for those seven (or eight) figure bonuses?
Why are so many companies announcing buyback programs now? A cynic might say because companies are scared to death about what is happening in the world and they are looking to prop up their share prices in any way possible, knowing that the market often reads too much positive news into share buyback announcements. But most of this quarter’s buyback announcements were made well before Putin invaded Ukraine and the most likely explanation for the rash of buyback announcements is that business has been good for quite a while now but the opportunities for large amounts of additional capital investment may look increasingly limited or risky. And maybe these companies really do think their shares are now “cheap” at prices down 20% or more in some cases but with forecasted earnings still strong. For some, perhaps the outlook for their businesses is not very good and returning cash to shareholders seems like a more productive use of capital than organic investment, paying down debt or holding excess cash. Any or all of these are possible explanations for the rash of buyback announcements so far this year. But keep in mind that a buyback announcement is not the same as a buyback transaction. And what we are witnessing now may be a lot less bullish than the press seems to believe. The phrase ‘whistling in the dark’ comes readily to mind, but then I am a cynic.
We will see if Goldman Sachs is right with their forecast of $1 trillion in total buybacks completed this year. But what will be even more interesting is to see what the world looks like at the end of this year, and how much those EPS-linked executive compensation packages turn out to have cost shareholders.
Links
Stock Buybacks On Course for Another Record, WSJ, March 15, 2022