Rules of thumb for investors when judging merits of share buyback
THE debate on corporate share buybacks continues in the wake of a year that saw share-repurchase schemes buy up an estimated $1 trillion in shares across the S&P 500 index. That’s almost 5pc of the market cap of the S&P500 index.
Share buybacks (also known as share-repurchase schemes) are where companies buy back their own shares on the open market — as a means of returning capital to shareholders.
As with most investment concepts, the value to individual investors of a share repurchase lies in how it’s carried out. To analyse the validity of an individual share repurchase, investors need to consider several factors — including the health of the company’s balance sheet, the opportunity cost, management’s motivation for the buyback, and the market value of the company.
The first point — balance sheet health — is a simple one. Investors need to question if the firm can afford to allocate cash to buying its own stock. Ideally, a company will be funding it from excess cash held on the balance sheet. If the share-repurchase scheme pushes debt above normal or sustainable levels, management’s motivation for the buyback needs to be questioned.
Considering a company’s investment opportunity is more complicated. As an investor, however, you can assume that management has assessed its opportunities and has arrived at a conclusion that returning funds to shareholders adds more value over investing in the business. The alternative would lead you to expect they’re not acting in the shareholders’ best interests.
Buybacks need to be considered in the context of management’s overall capital allocation (the allocation of financial resources to projects, products or business lines to maximise profit). Analysing management’s intentions is very important. Investors pay a premium for growth and earnings per share (EPS — a financial measure which indicates the profitability of a company) is a constant focus of management. An easy method of boosting EPS is to reduce the number of shares in issue, which would show a year-over-year increase in EPS — even if absolute earnings remained flat. Buybacks can also offer management and investors flexibility. Existing shareholders receive an unrealised gain (not taxable until realised) versus say a cash dividend (which would be taxed), while shareholders who would like to cash in some of their investment have the option to sell part of their holding.
Finally, valuation is a critical component of any equity purchase. Famed investor Warren Buffett’s view is that “when stock can be bought below a business’s value, it is probably the best use of cash”. While this is a simple rule, the intrinsic value of a company can be difficult to ascertain. As is the case for investors, companies need to be wary of valuation as purchasing stock at levels above a company’s intrinsic value destroys value for remaining shareholders.
Returning to the question at hand, share buybacks can generate value for shareholders and ultimately, will at the very least, provide support to a company’s share price in the short-term. To determine the longer-term value generated, investors need to assess management’s motivation. Ideally, the balance sheet will be holding high levels of cash and low net debt (the total debt of a company minus its cash in hand).
A share buyback is more appropriate for a mature business than younger high-growth businesses. The ideal scenario investors should look for would include a company with above-average cash flow, low net debt, a mature business with limited growth opportunities and, crucially, a company which is trading below intrinsic value.