Casey Research’s Chris Wood took an interesting look at the practice of stock buyback’s today. I liked his breakdown, and was actually surprised to see that companies are terrible timers of their own stock! Chris writes:
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.
Personally I don’t mind a company buying back its own shares – but I’m with Chris that those shares had better be undervalued. Buying back shares for the hell of it doesn’t make sense.
If shares ARE undervalued, and especially if they are significantly so, I’d rather see a company buyback shares than issue a dividend. Because a buyback of undervalued shares is a gift that keeps on giving. Plus, you avoid the dividend tax that way.
Recently we looked at Intel’s share price, and wondered aloud why the company is not buying back shares hand over fist, if INTC is as undervalued as CEO Paul Otellini laments constantly. On the other hand, Intel’s current cash cow – PC chips – probably won’t be what it is today in 10 years, perhaps even 5. Devices are getting smaller – think mobile phones and tablets – and Intel by and large is not making the chips in these devices. Which may explain why these laments are nothing more, as the company funnels cash flow into new R&D in hopes of making the chips that power the “next big thing.”
Thanks again to Chris for the solid analysis, and debunking the knee jerk bullish reaction to share buybacks.