Share repurchases or buybacks appear to be on the rise within the corporate community, preferring this methodology over payment of dividends to their shareholders. This is, perhaps, somewhat in response to the financial crisis that required many companies to terminate or freeze their dividend programs. Once a company implements a dividend program, the possibility or idea of cutting the dividend is repugnant.
Up till the early 1980s, 90% of shareholder distributions was through dividends. Today, nearly 60% of distributions are in the form of stock repurchases. There is nothing inherently defective in the process; however, the bottom line to repurchases is to determine whether the purchase is truly creating value.
We typically hear mostly about the increase in earnings attained through stock repurchases, which appears to be the No. 1 reason for implementation based upon statements issued from the individual companies. In theory, it is simple:
Example Company: ABC
Shares Outstanding: 50,000,000
Earnings: $150,000,000
Earnings per Share: $3.00
Company ABC decides to repurchase 5 million shares
Shares Outstanding: 45,000,000
Earnings: $150,000,000
Earnings per Share: $3.30
Other benefits of stock repurchases include improvements to some of the metrics, such as Return on Assets:
Example Company: XYZ uses $10,000,000 cash to repurchase shares
Assets: $100,000,000
Earnings: $4,000,000
Return on Assets: 4%
Stock repurchases reduce assets (cash)
Assets: $90,000,000
Earnings: $4,000,000
Return on Assets: 4.4%
Some of the reasons companies decide to repurchase shares are:
1. Preference over a dividend program which commits the company to regular payments. A repurchase program can be started and stopped at any time without completion of the buyback program.
2. Improve metrics or earnings per share which compensation may be based upon or pass along value to their shareholders.
3. The company buys back shares to offset the options they give to their employees.
In the 1984 Berkshire Hathaway Annual Report, Warren Buffett said, âWhen companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases" (emphasis is mine).
The point is that if a successful company cannot find a better place for their money, such as another investment, and their stock is undervalued, stock repurchases are one of the best means to benefit the shareholders. The problem is not with Buffettâs statement, but in the fact that most companies appear to have poor timing of their purchases when their companies are undervalued. In short, history appears to show that many, if not most CEOs are repurchasing their shares when they are not cheap, but overvalued. Therefore, they are really not creating value.
In 1999, Buffett goes on to say, â...companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised. This âbuy high,â âsell lowâ strategy is one many unfortunate investors have employed-but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully.â
This is extremely important because it may very well be the biggest reason management actually purchases shares and itâs prudent that every investor endeavor to determine exactly why the repurchasing is taking place and not believe that all repurchases are good things. In fact, I am inclined to be more cautious when I see stock repurchases.
Microsoft
Microsoft (MSFT, Financial) reportedly spent over $100 billion dollars on share repurchases just between 2004 and 2010. Between 2001 and 2010, outstanding shares were reduced by approximately 2 billion shares. It is generally acknowledged that the price of Microsoft has averaged around $26 through this 10-year period. Simple math would determine that 2 billion shares at an average price of $26 is equal to only $52 billion. What happened to the remainder? This is not judgment on Microsoft. This may have something to do with options, but the point is that this would require much more research. Do not assume that repurchases are good things. Often, they are not.
In 1997, Wall Street Journal staff members Suzanne McGee and Greg Ip wrote an article called, Buybacks Arenât Always A Good Sign For Investors, in which they discuss options and conclude that nothing has been gained if this is the reason for the repurchases.
It goes on to state, âIn a recent research report, the equity-strategy department at Salomon Brothers points out that while an employee usually buys shares for less than the market price under options programs, the company pays market price to buy them back. In dollar terms, the number of shares outstanding may seem to be shrinking, as the company has spent more to buy back shares than employees have spent to acquire them, but in fact the number of shares could remain unchanged or even growâ. Itâs smoke and mirrors.
You may argue that an increase in earnings or EPS in adequate, but that doesnât necessarily hold true. Above we saw how easily EPS can be increased; however, we are assuming that there is no affect on the P/E and that it remains static. But if debt has been incurred during the repurchase, we get higher leverage and a lower P/E which completely offsets the increase in the EPS.
Take the time to determine the reason for the repurchases. Read the announcements of repurchases with great caution because they often do not state the real reasons for the repurchase. Understand that repurchases can have beneficial or negative consequences.
Up till the early 1980s, 90% of shareholder distributions was through dividends. Today, nearly 60% of distributions are in the form of stock repurchases. There is nothing inherently defective in the process; however, the bottom line to repurchases is to determine whether the purchase is truly creating value.
We typically hear mostly about the increase in earnings attained through stock repurchases, which appears to be the No. 1 reason for implementation based upon statements issued from the individual companies. In theory, it is simple:
Example Company: ABC
Shares Outstanding: 50,000,000
Earnings: $150,000,000
Earnings per Share: $3.00
Company ABC decides to repurchase 5 million shares
Shares Outstanding: 45,000,000
Earnings: $150,000,000
Earnings per Share: $3.30
Other benefits of stock repurchases include improvements to some of the metrics, such as Return on Assets:
Example Company: XYZ uses $10,000,000 cash to repurchase shares
Assets: $100,000,000
Earnings: $4,000,000
Return on Assets: 4%
Stock repurchases reduce assets (cash)
Assets: $90,000,000
Earnings: $4,000,000
Return on Assets: 4.4%
Some of the reasons companies decide to repurchase shares are:
1. Preference over a dividend program which commits the company to regular payments. A repurchase program can be started and stopped at any time without completion of the buyback program.
2. Improve metrics or earnings per share which compensation may be based upon or pass along value to their shareholders.
3. The company buys back shares to offset the options they give to their employees.
In the 1984 Berkshire Hathaway Annual Report, Warren Buffett said, âWhen companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases" (emphasis is mine).
The point is that if a successful company cannot find a better place for their money, such as another investment, and their stock is undervalued, stock repurchases are one of the best means to benefit the shareholders. The problem is not with Buffettâs statement, but in the fact that most companies appear to have poor timing of their purchases when their companies are undervalued. In short, history appears to show that many, if not most CEOs are repurchasing their shares when they are not cheap, but overvalued. Therefore, they are really not creating value.
In 1999, Buffett goes on to say, â...companies say they are repurchasing shares to offset the shares issued when stock options granted at much lower prices are exercised. This âbuy high,â âsell lowâ strategy is one many unfortunate investors have employed-but never intentionally! Managements, however, seem to follow this perverse activity very cheerfully.â
This is extremely important because it may very well be the biggest reason management actually purchases shares and itâs prudent that every investor endeavor to determine exactly why the repurchasing is taking place and not believe that all repurchases are good things. In fact, I am inclined to be more cautious when I see stock repurchases.
Microsoft
MSFT - Shares Outstanding | |||||||||
2001 | 2002 | 2003 | 2004 | 2005 | 2006 | 2007 | 2008 | 2009 | 2010 |
10764 | 10831 | 10736 | 10795 | 10804 | 10201 | 9567 | 9313 | 8900 | 8764 |
Microsoft (MSFT, Financial) reportedly spent over $100 billion dollars on share repurchases just between 2004 and 2010. Between 2001 and 2010, outstanding shares were reduced by approximately 2 billion shares. It is generally acknowledged that the price of Microsoft has averaged around $26 through this 10-year period. Simple math would determine that 2 billion shares at an average price of $26 is equal to only $52 billion. What happened to the remainder? This is not judgment on Microsoft. This may have something to do with options, but the point is that this would require much more research. Do not assume that repurchases are good things. Often, they are not.
In 1997, Wall Street Journal staff members Suzanne McGee and Greg Ip wrote an article called, Buybacks Arenât Always A Good Sign For Investors, in which they discuss options and conclude that nothing has been gained if this is the reason for the repurchases.
It goes on to state, âIn a recent research report, the equity-strategy department at Salomon Brothers points out that while an employee usually buys shares for less than the market price under options programs, the company pays market price to buy them back. In dollar terms, the number of shares outstanding may seem to be shrinking, as the company has spent more to buy back shares than employees have spent to acquire them, but in fact the number of shares could remain unchanged or even growâ. Itâs smoke and mirrors.
You may argue that an increase in earnings or EPS in adequate, but that doesnât necessarily hold true. Above we saw how easily EPS can be increased; however, we are assuming that there is no affect on the P/E and that it remains static. But if debt has been incurred during the repurchase, we get higher leverage and a lower P/E which completely offsets the increase in the EPS.
Take the time to determine the reason for the repurchases. Read the announcements of repurchases with great caution because they often do not state the real reasons for the repurchase. Understand that repurchases can have beneficial or negative consequences.
