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How to Check for Smart Stock Buybacks

Ser Jing is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.

Stock buybacks are often touted by management as a way to return value to stockholders. The basic idea is that the buybacks will enhance stock-specific value for stockholders such as Earnings Per Share. By owning a larger piece of the existing company, stockholders are entitled to a larger slice of the company’s profits.

However, stock buybacks can destroy value for stockholders if management does not engage in them with the right mindset. Often, management will have a Stock Repurchase Program that is authorized by the Board of Directors where a fixed amount of money is allocated to purchase stock within a fixed timeframe. Sometimes, the criteria for stock repurchase programs are not spelled out clearly and it is up to management to decide whether the current stock price represents good value for repurchase. As investors in the company, we should have a rough idea on what prices represent good value and can use that as a gauge for how well management has allocated this capital.

Often, a cursory glance at a company’s income statement in their 10K or 10Q reports will highlight how the number of outstanding stock has changed over the years. If the number is decreasing, that means management has been returning value to stockholders, right? Not so fast – we should also look at how much money has been spent as well as the price that management paid for the stock.

Let’s take a look at Coach (NYSE: COH). From its latest 10K, diluted stock count had decreased from 315.8 million in FY2010 to 294.1 million in FY2012, yet Coach spent a total of $2.95 billion to repurchase 61.8 million shares. You might have noticed that the diluted stock count only decreased by 21.7 million whereas 61.8 million stocks were repurchased. Where did those extra shares go? They were actually part of stock-based compensation plans for Coach’s management and employees.

Doing some basic calculations reveals that $1.91 billion had actually been spent to offset dilutive effects due to stock-based compensations and thus only 35% of the $2.95 billion that management had spent on stock repurchases had returned value to existing stockholders. While I'd like to see a higher percentage of this money used to reduce the actual diluted stock count, stock-based compensation plans are a fact of corporate life.

I have compiled a table of a few other stocks that have had meaningful reductions in diluted stock count over their three most recent fiscal years, and for comparison, one company that has spent substantial amounts of money on stock repurchases even though its diluted stock count has hardly budged.

Companies like Activision Blizzard (NASDAQ: ATVI), Coach and Panera Bread (NASDAQ: PNRA) have all used a substantial chunk of their stock repurchase money to offset dilution. But Logitech (NASDAQ: LOGI) takes the cake here as a whooping 85% of the money spent has been used to offset dilution. Stockholders in Logitech might feel the $282 million they spent on stock buybacks could be better served for other purposes, such as growing the business or for dividends.

<table> <tbody> <tr> <td> <p> </p> </td> <td> <p>Activision Blizzard</p> </td> <td> <p>Coach</p> </td> <td> <p>Panera Bread</p> </td> <td> <p>Logitech</p> </td> </tr> <tr> <td> <p>Starting Stock Count</p> </td> <td> <p>1,311 million</p> </td> <td> <p>315.8 million</p> </td> <td> <p>30.98 million</p> </td> <td> <p>179.3 million</p> </td> </tr> <tr> <td> <p>Ending Stock Count</p> </td> <td> <p>1,156 million</p> </td> <td> <p>294.1 million</p> </td> <td> <p>29.90 million</p> </td> <td> <p>175.6 million</p> </td> </tr> <tr> <td> <p>Total Number of Stock Purchased</p> </td> <td> <p>261.1 million</p> </td> <td> <p>61.8 million</p> </td> <td> <p>2.809 million</p> </td> <td> <p>24.9 million</p> </td> </tr> <tr> <td> <p>Total Amount Spent</p> </td> <td> <p>$2,898 million</p> </td> <td> <p>$2,950 million</p> </td> <td> <p>$242.5 million</p> </td> <td> <p>$282 million</p> </td> </tr> <tr> <td> <p>% of stock used to offset dilution from<br /> stock-based compensation</p> </td> <td> <p>40.6%</p> </td> <td> <p>65%</p> </td> <td> <p>61.5%</p> </td> <td> <p><strong>85%</strong></p> </td> </tr> </tbody> </table>

Another aspect on the usefulness of the stock buyback program is the price that management paid for the stocks. Coach paid an average price of $65.40 for its stock repurchases done in FY2012. Coach had an EPS of $3.53 for FY2012 and so the stock was traded at a PE of 18.5 -- not too far from its current TTM PE of 16.05, which suggests that management doesn't purchase stocks indiscriminately, but rather tries to buy back stock when they feel it is undervalued.

Contrast this with Netflix’s (NASDAQ: NFLX) situation, where management bought stock when it was trading at $300/share in July 2011 at a TTM PE of 88. One can certainly make a strong case for Netflix’s stock being overvalued at that point and management’s capital allocation was poor.

Stock buybacks are often touted by management as ‘returning value’ to stockholders, however, it pays to take a closer look to see how much money is actually being returned to stockholders and to see if management has been buying stock back wisely. These little details can help you get a clearer picture of management’s capital allocation capabilities, which is important because we want our money to be put to work in the best possible way. 

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serjing owns shares of Activision Blizzard, Panera Bread, and Netflix. The Motley Fool owns shares of Activision Blizzard, Coach, Logitech International SA (USA), Netflix, and Panera Bread. Motley Fool newsletter services recommend Activision Blizzard, Coach, Logitech International SA (USA), Netflix, and Panera Bread. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy. If you have questions about this post or the Fool’s blog network, click here for information.

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