Are Stock Buybacks a Waste of Money?
William is a member of The Motley Fool Blog Network -- entries represent the personal opinion of the blogger and are not formally edited.
When some companies buy their own stock they spend billions of dollars that provide no tangible benefit to the shareholders at large and offer only theoretical value at best. Share repurchases are therefore a waste of resources, and there are better, more tangible uses of money spent on shareholder repurchases.
How Share Repurchases are Carried Out
Share repurchases are carried out in one of two ways: 1) Companies go to the open market to buy the stocks, or 2) Companies issue a tender offer for shares and buy them at a premium to the current market price per share. An example of a company issuing a tender offer is Seaspan. On December 13, 2011 they announced plans to buy their own stock at $15 per share, which back then was a 43.5% premium to the market price per share. The company is now trading around $15 per share. Whether the current stock price is a result of the premium offer is difficult to tell for sure. After a company buys the shares, they put them in a treasury stock account and they are not used in the shares outstanding calculation.
Reasons for Share Repurchases
There are many reasons that companies repurchase their stock. One reason is to simply reduce the shares outstanding, thus reducing supply and increasing the price per share. While this reason sounds good, the benefits are mostly theoretical. For example, McDonald’s (NYSE: MCD) had 1.083 billion shares at the end of 2010. They purchased 3.4 billion dollars’ worth of their own stock in 2011, leaving 1.044 billion shares. The market cap of this company increased roughly 22 billion dollars during this time. How much of this increase was attributable to the share repurchase program and how much of this success was owed to market enthusiasm is difficult to decipher.
Another reason includes management’s desire to improve financial ratios. For example, when cash is paid out it reduces the assets on a company’s balance sheet thus improving return on assets. Also, there is an argument that it is advantageous from a shareholder’s standpoint in that share repurchases are not taxable.
Management also likes to buy their own company’s stock because it projects the impression to the market that the stock is undervalued or they want to demonstrate loyalty by not investing the money in another company’s stock. Buying back company stock reduces shares outstanding, which in turn increases the heavily watched earnings per share without really boosting earnings. Warren Buffett looks at his Berkshire Hathaway (NYSE: BRK-A) stock as another investment. If Berkshire Hathaway is trading below intrinsic value then he initiates a stock buyback. If Berkshire Hathaway is above intrinsic value then he deploys cash elsewhere. This is the way management should approach share repurchases. If a company wants to deploy cash to share repurchases then buying below intrinsic value would make sense because they aren’t overpaying for the shares.
Better Ways to Deploy Cash
There are better ways to deploy cash that provide more tangible benefits to the shareholder and/or the fundamentals of the business. One way is to take the cash that is used for stock buybacks and pay a dividend. Of course, if your shares are in a taxable account the dividends will be taxed. Keep in mind, though, that some people keep shares in a tax free retirement account and that dividends are taxed at a much lower rate than ordinary income. Also, dividends could provide two tangible benefits given certain market reactions and attitudes. (See Table Below)
Let’s take Hewlett Packard (NYSE: HPQ) for example. Currently the stock is yielding around 3%. In 2011 they spent 10.1 billion dollars on stock repurchases. That money divided by 2010 weighted diluted shares outstanding, or the calculation that factors in dilutive factors such as stock options, you arrive at $4.27 per share spent on stock buybacks. I use this number because they wouldn’t have bought these shares if they went with this wild scenario of mine. Assuming they paid this out in dividends instead of buying stock, the new dividend would have been $4.80 or 27% rounded up. If the market adjusted the yield back down to its current level of 2.95%, the stock price would be $162.76 per share. This is an astounding 805% return. I am not sure if the market would tolerate the higher p/e ratios listed below so the return may not be that much. However, even a lower gain combined with a higher yield would make for a superior gain on your investment. Paying out dividends to provide a tangible benefit in the form of cash and increasing the chance of higher market price to compensate for average market yield is better than the theoretical supply and demand boost that is currently touted.
|Company||Current Price Per Share (07/24/12)(1)||2011 Money Spent on Buybacks (in millions) (2)||2010 Weighted Diluted Shares Outstanding (In Millions)(2)||Cash Per Share Spent on Buy Backs(3)||Current Dividend Per Year(1)||Adjusted Dividend based on buyback money (4)||Dividend Yield 07/24/12 (5)||Adjusted Dividend Yield Based on Market Price 07/24/12||Stock Price if Adjusted back to previous yield||Stock Price Difference (6)||Current P/E 07/24/12 (1)||P/E Adjusted for new Stock Price (7)|
|(1) Source Yahoo Finance|
|(2) 2011 Form 10-K|
|(3) Money Spent on Buybacks dividend weighted diluted average shares outstanding|
|(4) Current dividend + Cash Per Share Spent on Buy Backs|
|(5) Current Dividend Per Share divided by market price expressed as %|
|(6) Calculated by taking adjusted dividend per share and dividing it by current yield|
|(7) Adjusted stock price divided by eps according to Yahoo! Finance|
Another, better use for stock buyback cash is using this cash to pay down debt or at the very least providing enough cash to fund future operations without outside financing. Cash could also be used to fund acquisitions without outside help as well.
In the chart below, companies could significantly reduce their debt to equity ratios. For instance Intel (NASDAQ: INTC) spent $14.3 billion dollars on share repurchases in 2011. Intel could have used their share repurchase money and reduced their long-term debt to equity ratio from 55% to 24% in 2011. Considering that tech companies are constantly facing obsolescence they should be mindful to hang on to their cash for acquisition of future companies or technologies that could be of benefit to them and their shareholders. Coca-Cola (NYSE: KO) had a surprising long-term debt to equity ratio of 43% in 2011. Coca-Cola could have used their share repurchase money of 4.5 billion dollars to reduce their long-term debt to equity ratio from 43% to 29%. Reducing debt or stockpiling cash gives a company more financial flexibility and the ability to operate in tough times without outside help. Another, better use for stock buyback cash is using this cash to pay down debt or at the very least providing enough cash to fund future operations without outside financing. Cash could also be used to fund acquisitions without outside help as well.
|Company||Long-Term Debt(1)||2011 Money Spent on Buybacks (in millions)(1)||Stockholder's Equity (2011)(1)||Debt After payoff (2)||Long-Term Debt to Equity Ratio(3)||Long-Term Adjusted Debt to Equity Ratio(4)|
|(1) 2011 Company Form 10-K|
|(2) Long-Term Debt - Money Spent on Buybacks|
|(3) Long-Term Debt divided Stockholder's Equity Expressed as %|
|(4) Long-Term debt after payoff divided by stockholder's equity express as %|
The next time you see a company announce a share repurchase program think about what it means and consider other ways the cash could be used. The cash could go into your own pocket in the form of a dividend and help augment the stock price from income seeking investors. Other companies could be acquired to augment product portfolios. Think about what they could do in the next sector downturn with the money to become more competitive. Using cash for share repurchases is like throwing money into the wind.
If you would like more information on the topic of share buybacks I just came across this article after completing my research: Investors: You’re Being Duped by Share Buybacks by Sean Williams.
stockdissector has positions in McDonald's, Berkshire Hathaway Class B, and Intel mentioned above. The Motley Fool has no positions in the stocks mentioned above. 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.