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After the market close on Tuesday, Cummins Inc. (CMI) announced an additional $1B stock buyback. The stock was up roughly 1% in after-hours based on the news, but shareholders should ignore this supposedly good news.

The manufacturer of diesel engines has historically bought its own stock over the last 5 plus years so investors should not be surprised by such a move. The company continues to make strong profits so the lack of an additional buyback program would be more abnormal.

More importantly, the company approved the buyback program as the last $1B approval in February 2011 comes to a close. Effectively the company has taken nearly 2 years to complete a buyback that amounts to 5% of the outstanding shares or market value. Over 2 years, the buyback will only amount to roughly 2.5% of the outstanding shares each year.

Stock Buyback History

For the stock buyback to be significant enough to sway investors, the amount needs to be considerably higher. A level suggesting that the stock trades at an extreme valuation compared to the assets and profit generation of the company.

In the case of this buyback based on historical results, it appears that the company has become more aggressive as the stock has risen significantly. Notice how the chart below shows a less aggressive reduction in shares outstanding when the stock price was around $50 from 2008 to 2010. As the stock approached $100 in mid 2010, the buyback appears to have increased.

CMI Shares Outstanding Chart

CMI Shares Outstanding data by YCharts

These results back the typical investor opinion that buybacks are worthless. Remember that while the company claims that a buyback is a reward to shareholders, it only rewards them if the company purchases the shares at significant discount to the net present value. Otherwise, the company forecast higher stock prices in the future to make the current price of $105 worthy of spending precious cash. The $1B buyback appears more a standard move than anything strategic.

Net Payout Yields

Combined with a 2% dividend yield, the company has a solid 4-5% net payout yield. The net payout yield is the combination of the net buyback yield and the dividend yield. The average stock in the net payout yields top 10 yields 16% with buybacks on average over 10%. Those levels of buybacks signal real value compared to the limited amount undertaken by Cummins.

Conclusion

Anybody investing in Cummins should base the decision on the prospects of the company and not the stock buyback. In fact, the preference would be for Cummins to undertake a more strategic buyback where cash is conserved for periods of extreme stock weakness and not used on a routine basis to purchase shares.

Source: Ignore The Cummins Buyback

Additional disclosure: Please consult your financial advisor before making any investment decisions.