Share Buybacks And Shareholder Value
Share buybacks often get a bad reputation, one I believe they don’t deserve.
Buybacks are often unfairly criticized in the media when instead, it is the actions of the company management itself which leads to the destruction of shareholder value.
Share buybacks themselves are not the problem. As will be shown below, when done properly, share buybacks are an effective way for returning value to shareholders, i.e. the rightful owners of the company.
The failure is when incompetent managements use share buybacks improperly, or even worse, purposefully enrich themselves through lavish options at the expense of company shareholders and then attempt to hide the thievery with share buybacks.
Let’s take a look at exactly what share buybacks are and how they can be used and misused. Understanding the differences are essential for making sound investments.
What Is A Share Buyback?
Share buybacks, also known as stock buybacks or share repurchases, are when a company uses its cash to buy back shares of the firm, rather than put the money to use elsewhere.
Why would a company want to buy back its shares?
Perhaps the management hasn’t found any good opportunities to put the company’s capital to use. This is often a wise choice.
Rather than using the money to acquire another company or upgrade existing facilities, the management feels that their companies stock is clearly undervalued and that the best use of their money would be to purchase their shares and retire them.
Unfortunately, too many companies go on buying sprees, using a growth-at-any-cost strategy, scooping up competitors or smaller related companies, all the while proclaiming that “synergies” between them will improve the company as a whole.
While those synergies do indeed sometimes happen, they can be very hard to pull off. Far too often, companies with very different work cultures, technologies, and ways of doing things, fail to produce the benefits first envisioned.
When those synergies never materialize, the acquisition fails, and the acquiring company has to write off the entire overpriced purchase as “goodwill.” The term goodwill is the difference in the actual assets and the price paid for them. It shows that the acquisition was ultimately a failure.
Share Repurchase Advantages
In talks with value investor Monish Pabrai, Charlie Munger recommended Pabrai to “look at the cannibals,” meaning to look for companies that buy back significant amounts of their shares. There are some excellent reasons for investing in companies that are buying back their stock.
Likewise, Warren Buffett, arguably one of the best investors alive, is a big fan of stock buybacks:
“When 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.”
While the managers of companies are often excellent at running their businesses, it is not uncommon to find that many of them are poor capital allocators, as value investor Lou Simpson explains:
“Managers who run a profitable business often use excess cash to expand into less profitable endeavors. Repurchase of shares is in many cases a much more advantageous use of surplus resources.”
Increase In Earnings Per Share
Share buybacks, lower the number of shares outstanding, which increases the earnings per share and value of each share relative to the underlying assets of the firm.
Even if a company’s net income is no longer growing, stock buybacks will increase the earnings per share. As the share count is reduced through the buyback, the total earnings per share will in turn increase.
Ultimately, as earnings per share continue to increase over time, investors will take notice and the price of the stock will rise.
Advantage Over Dividends
Dividends are one way to return value to shareholders, and while they are often preferred by retirees who need income to live, they do have one substantial disadvantage when compared to share buybacks.
Dividends are taxable, but share buybacks are not.
The act of buying back shares is tax-free which cuts out the taxman. When done correctly, share buybacks are the most efficient use of the company’s and shareholders’ money.
Jason Zweig explains:
“Unlike a dividend, a buyback is tax-free to investors who don’t sell their shares. Thus it increases the value of their stock without raising their tax bill. And if the shares are cheap, then spending spare cash to repurchase them is an excellent use of the company’s capital.”
How high can those taxes on dividends be? Perhaps higher than you might at first think.
Profits made by a company are first taxed at the corporate tax rate, which can vary. Corporate taxes can be as low as 15% or as high as 39% in the United States.
After being paid out to shareholders, any dividends would then again be taxed.
At the time of writing, at the highest rate for individuals in the United States, if they are “qualified” dividends then they will be taxed at a rate of 20% for higher income taxpayers. In contrast, if they are “non-qualified” dividends then they are taxed at as ordinary income, which can be as high as 39.6% for higher income taxpayers.
However, no matter which tax bracket you fall into, the basic idea stays the same. It is best to pay the least amount of tax that is legally allowed.
For individuals not immediately needing income, stock buybacks are a legal way to return value to shareholders in a tax-free manner.
How Share Buybacks Should Be Done
Share repurchases should be carried out when the company’s stock price is trading below its intrinsic value. The price paid is important.
“The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another.” – Warren Buffett
Explaining in much more depth, Warren Buffett explains how stock buybacks should be performed:
“Charlie and I favor repurchases when two conditions are met: first, a company has ample funds to take care of the operational and liquidity needs of its business; second, its stock is selling at a material discount to the company’s intrinsic business value, conservatively calculated. We have witnessed many bouts of repurchasing that failed our second test. Sometimes, of course, infractions – even serious ones – are innocent; many CEOs never stop believing their stock is cheap. In other instances, a less benign conclusion seems warranted. It doesn’t suffice to say that repurchases are being made to offset the dilution from stock issuances or simply because a company has excess cash. Continuing shareholders are hurt unless shares are purchased below intrinsic value.”
Share repurchases need to be done when the company’s share price is below its intrinsic value when company shares are selling at a bargain. Share buybacks above intrinsic value would mean that the company is overpaying, which is not a good capital allocation policy.
AutoZone, one of the leading retailers and distributors of automotive replacement parts and accessories in the United States, is often used as an example of the power of stock repurchases.
Since 1998 when AutoZone first initiated its share repurchase program, the board of directors has authorized $17.2 billion in stock buybacks. In 1998 AutoZone had 160 million in shares outstanding but as of the time of writing in 2016, AutoZone now has just over 29 million shares. That a decrease of an astounding 82% in the number of shares. Over those same 18 years, due to the help of stock buybacks, the stock price of AutoZone has risen to an astounding 2,779% from $28.81 to $813.97. For the individual investor, that is certainly an excellent return for doing nothing more than buying and holding a stock.
Now, I admit that I didn’t take the time to go back through all of the historical data to try and make sure that all of those buybacks took place when shares of AutoZone were trading below their intrinsic value. There is a possibility that they were not.
However, I think it has been shown that consistent share buybacks over an extended period can have a tremendous effect on a company’s stock price.
Using Stock Buybacks To Hide Stock Options
Stock buybacks for management’s self-enrichment
Many managements of high-growth companies, especially in the technology sector, give themselves lavish stock options. One common argument is that stock options will help align the interests of the managers with those of the shareholders. However, giving out stock options destroys shareholder value as it increases the number of shares relative to the earnings and assets of the company.
Instead of aligning interests with shareholders, C-suite executives often improperly use options to enrich themselves and then to attempt to cover up the dilution of shares by authorizing stock buybacks. More often than not, share buybacks used to cover up the excessive use of options, are done when their company’s shares are trading at high multiples instead of low ones, which further destroy shareholder value.
Jason Zweig, financial author and columnist of The Wall Street Journal had this to say on the subject of the improper use of stock buybacks to hide lavish options:
“Companies should buy back their shares when they are cheap – not when they are at or near record highs. Unfortunately, it recently has become all too common for companies to repurchase their stock when it is overpriced. There is no more cynical waste of a company’s cash – since the real purpose of that maneuver is to enable top executives to reap multimillion-dollar paydays by selling their stock options in the name of ‘enhancing shareholder value.'”
Jason Zweig goes on to show how this improper behavior has not only become pervasive in the tech industry but what could even be described as he believes as… well… evil:
“Unfortunately, in the real world, stock buybacks have come to serve a purpose that can only be described as sinister. Now that grants of stock options have become such a large part of executive compensation, many companies – especially in high-tech industries – must issue hundreds of millions of shares to give to the managers who exercise those stock options. But that would jack up the number of shares outstanding and shrink earnings per share. To counteract that dilution, the companies must turn right back around and repurchase millions of shares in the open market.”
Companies and shareholders alike, benefit from management actions that focus on the long-term, those that lay a solid foundation to increase earnings and market share in the years and decades ahead. However, the giving of stock options to executives do not encourage a long-term owner mentality.
Instead, after the stock options vest, the managers are no longer obligated to hold their shares, thereby promoting short-term thinking by the management. As executives of the company who have stock options will benefit more from stock price volatility and so favor stock buybacks over dividends, as Jason Zweig explains:
“A senior executive heavily compensated with stock options has a vested interest in favoring stock buybacks over dividends. Why? For technical reasons, options increase in value as the price fluctuations of a stock grow more extreme. But dividends dampen the volatility of a stock’s price. So, if the managers increased the dividend, they would lower the value of their own stock options.”
According to Maggie Mahar, the author of Bull! A History Of The Boom And Bust, 1982-2004, just the announcement of a stock buyback program tends to boost share prices, even if it is never carried out and increases the short-term value of management’s options. This is another reason why executives who have stock options prefer stock buybacks over dividends.
Many of the best value investors seek out companies which are consistently buying back their shares and for a good reason.
When a firm’s stock is trading below its intrinsic value, share buybacks have been shown to be effective in increasing shareholder value and raising the company’s stock price.
Share buybacks, when done properly, increase shareholder value.
Keep an eye on stock options awarded to management in relation to share repurchases for nefarious activities.
Companies That Do Buybacks Do Worse Over Time
Charlie Munger’s 3 Rules On How To Become A Successful Investor
The Value Of Share Buybacks
Stock Buybacks: They Are Big, They Are Back And They Scare Some People!
AutoZone Authorizes Additional Stock Repurchase
Why AutoZone Might Have Gone Too Far With Stock Buybacks
Bull! A History Of The Boom And Bust, 1982-2004 By Maggie Mahar.