Solve the share buyback riddle

Share repurchases are a great way for companies to return surplus capital to shareholders — even if it is not always well-received by investors.

This is because when a company announces it is repurchasing shares, it’s often interpreted as negative. It’s as if the company is admitting it doesn’t have any constructive projects to undertake.

Before repurchasing shares, a company should examine reinvestment opportunities in its core business. These may consist of projects to increase efficiency, R&D to introduce new products, business or geographic expansion, or making an acquisition. Alternatively, the company can make unrelated business acquisitions, but this works best when it’s a conglomerate that already has the experience and infrastructure to run a diversified mix of companies.

Acquisition option

Expansionary activities are only beneficial if the rate of return is positive and adds to the value of the business. But the danger is that management is inclined to make the company bigger at any cost, instead of growing wisely by only investing if it adds to the future of the business. When companies start paying elevated prices for businesses, the net benefits have shrunk. Also, management should only add businesses they have experience in, or know how to manage.

The alternative often leads to paying rich prices for ill-advised mergers and acquisitions that don’t end up earning their keep.

In this case, the best option for investors is for management to return the excess cash to shareholders through buybacks or dividends. But if the company’s shares are undervalued, a repurchase of its own shares may be the best payoff.

Stock valuation

Determining a stock’s value is a subjective exercise with numerous approaches. But if a company’s management team believes its shares are undervalued, then they’re implying the expected future stream of earnings justifies a higher stock price.

Under these circumstances, buybacks are a sure way to put the company’s excess funds to good use. After all, how can an investor go wrong when he’s buying $1 of value for 80 cents or less? This produces a good return on investment, and reduces the overall share count, leaving the remaining investors with a larger slice of the equity pie. It also allows long-term investors to keep increasing their stakes without cost or effort.

But the determining factor for success is whether the shares are repurchased at the right price, and for the right reasons.

When a company announces a stock buyback, take a closer look at what’s behind the decision. Other than the usual rhetoric of returning the company’s wealth to shareholders, there are many less altruistic reasons like improving balance sheet ratios or fending off corporate takeovers.

Management is not likely to fess up to the real motives behind a repurchase. With a little research, investors can read between the lines and come to their own educated conclusions.

Here’s how.

• EPS and PE ratios:

  When shares are repurchased, key metrics like earnings per share (EPS) and the price earnings (PE) ratio look better because the share count falls. Whether the intention is to meet analysts’ estimates and prop up the stock price, or for management to meet its EPS-based compensation targets, keep a safe distance from these activities.

• Excessive debt:

  Be wary of companies who take on excessive debt to buy back shares (or to pay dividends). These companies aren’t returning capital; instead, they’re taking on risk, and will ultimately hold future capital hostage to interest and principal payments. Take a look at the balance sheet to see if net borrowings are rising in the face of repurchases.

• Reason for repurchase:

  A majority of companies simply repurchase shares to counteract the effects of warrants and options, and are willing to buy them at any cost to the detriment of shareholders. Make sure the net change in shares is diminishing over time, not simply that shares are being repurchased.

Other companies are enticed to repurchase to fend off takeovers by other companies. And some put a share repurchase program in place simply because it’s in fashion.

Such buyback behaviour is reckless. For example, in the third quarter of 2007, when stock prices were near all-time highs, members of the S&P 500 index repurchased $171 billion of stock. In the first quarter of 2009, when stocks were low, the same companies spent a mere $31 billion on buying back shares. Perhaps fear and depressed cash flows explain some of the difference, but the discrepancy is eye-opening.

Ideally, share repurchase programs should focus on price and be clear on the purchase criteria. Search for companies that have significant insider ownership — these are more likely to have a quality buyback program given the aligned interests with shareholders.

Such a program is in place at Berkshire Hathaway. The company vows to only repurchase shares when its stock trades at 120% of book value per share or less (a price management believes to be a bargain for remaining shareholders). This is a sign of a shareholder-oriented management team.

Dividends

Given the legwork involved, many investors prefer to receive their shares of the company’s earnings in dividends. This option puts cash directly in investor’s pockets. Dividends are also easier to quantify compared to the less tangible gains of repurchases.

But dividends are not as tax efficient because they’re taxed in the year received. Meanwhile, share repurchases allow long-term investors to defer taxes on any capital gains — which are taxed at a lower rate than dividends — until the shares are eventually sold.

These analytical tools will help you determine management’s true motive for share repurchases, as well as the preferred method of financing, so you can decide whether it’s an initiative that’ll create or destroy shareholder value.

Susy Abbondi is an equities analyst at Duncan Ross Associates.