The Value Of Share Repurchases

Includes: IBM, KMB, PG, T, TGT
by: Eli Inkrot

There are four basic options available to a company when they make a profit, or earnings: sit on the cash, reinvest in profitable opportunities, pay a dividend or buyback shares. Surely there are other alternatives out there, but let's imagine that the average company's management is firmly tied to the future prospects of their business such that inefficient jet planes and weekend company sponsored golf trips are kept at a minimum.

The first three earnings options are relatively straightforward. Much in the same manner that an individual needs an emergency fund for unforeseen expenditures like a car accident or a root canal; a company needs a rainy day fund for unexpected outflows. In fact, having some money in cash or short-term securities is apt to be an intelligent strategy. However, eventually the opportunity cost of holding too much cash becomes burdensome such that other opportunities need to be explored. Reinvesting in profitable opportunities is likely the most important use of a company's leftover earnings. After-all this is precisely why we invest in profitable firms. We cannot go out and sell Coca-Cola (KO), Johnson & Johnson (JNJ) or Procter & Gamble (PG) products on our own. But we do have the wonderful opportunity to become a part-owner in the profitable process. These companies can take the profits and use them in a value creating manner that we ourselves could not accomplish. For example, Coca-Cola as a company has the ability to build a bottling plant in India or Procter & Gamble has the ability to use earnings for research and development, making even more money in the future.

Eventually, even the profitable opportunities subside. Sooner or later a company begins to make so much money that it cannot find applicable alternatives. Here's where the dividend comes in. Instead of KO buying a paper company or JNJ investing in a chain of pizza restaurants, investors would likely rather have the additional profits in the form of a timely cash payment. This makes sense: as an investor you are a part-owner and thus you should be compensated. And nothing says compensation like cold hard cash. Given the option, we would like for this dividend to grow through time such that one's purchasing power increases.

It's not difficult to understand the first three options. In fact, they are directly comparable to the individual: establishing an emergency fund, investing in yourself and reaping the fruits of your labor. However, the fourth option can be difficult to mentally quantify: Share buybacks. If you read enough annual letters, invariably you will see a phrase like: "we returned XX amount of dollars to shareholders in the form of dividends and share buybacks". But how exactly does the share buyback create value? Allow us to run through some illuminating examples to find out.

Imagine a company that has 100 shares outstanding and made $100 last year. People are willing to pay 15 times earnings for the company, for an overall value of $1,500. This means that the current share price is $15. Additionally, the company has a payout ratio of 50%, meaning that the company will pay out $50 in total dividends, or $0.50 for each share outstanding. This equates to a 3.33% dividend yield and leaves the company with $50 in leftover earnings. For simplicity will we assume that the entire leftover $50 will be used for share buybacks. What value does this create over the next decade?

Earnings Stagnant            
  Shr Repurch Shares Out Earnings Value Div / Share EPS Share Price
Year 0 0.00 100 $100 $1,500 $0.50 $1.00 $15.00
Year 1 3.33 96.67 $100 $1,500 $0.52 $1.03 $15.52
Year 2 3.22 93.44 $100 $1,500 $0.54 $1.07 $16.05
Year 3 3.11 90.33 $100 $1,500 $0.55 $1.11 $16.61
Year 4 3.01 87.32 $100 $1,500 $0.57 $1.15 $17.18
Year 5 2.91 84.41 $100 $1,500 $0.59 $1.18 $17.77
Year 6 2.81 81.59 $100 $1,500 $0.61 $1.23 $18.38
Year 7 2.72 78.87 $100 $1,500 $0.63 $1.27 $19.02
Year 8 2.63 76.25 $100 $1,500 $0.66 $1.31 $19.67
Year 9 2.54 73.70 $100 $1,500 $0.68 $1.36 $20.35
Year 10 2.46 71.25 $100 $1,500 $0.70 $1.40 $21.05

Notice that I assumed that earnings were stagnant for 10 straight years. That is, in each year the company made $100, paid out $50 in dividends and used the leftover $50 for share buybacks. In reality one would hope earnings grow. Additionally, a constant assumption of a 15 P/E is not reasonable. However, it is interesting to note the value that has been created solely by repurchasing shares. The total dividend paid does not increase, yet the dividend per share is able to grow from $0.50 a share to $0.70. The earnings per share grow at the same rate from $1 to $1.40 by the end of year 10; without making any more money. Finally the share price moves from $15 to $21.05, at the same 3.4% growth rate. Personally I would take solace in the fact that a company doesn't have to find new projects or make any more money than it is today for my investment to be worthwhile.

Perhaps a more realistic example would spark your interest greater still.

Earnings Grow at 5%            
  Shr Repurch Shares Out Earnings Value Div / Share EPS Share Price
Year 0 0.00 100 $100 $1,500 $0.50 $1.00 $15.00
Year 1 3.33 96.67 $105 $1,575 $0.54 $1.09 $16.29
Year 2 3.22 93.44 $110 $1,654 $0.59 $1.18 $17.70
Year 3 3.11 90.33 $116 $1,736 $0.64 $1.28 $19.22
Year 4 3.01 87.32 $122 $1,823 $0.70 $1.39 $20.88
Year 5 2.91 84.41 $128 $1,914 $0.76 $1.51 $22.68
Year 6 2.81 81.59 $134 $2,010 $0.82 $1.64 $24.64
Year 7 2.72 78.87 $141 $2,111 $0.89 $1.78 $26.76
Year 8 2.63 76.25 $148 $2,216 $0.97 $1.94 $29.07
Year 9 2.54 73.70 $155 $2,327 $1.05 $2.10 $31.57
Year 10 2.46 71.25 $163 $2,443 $1.14 $2.29 $34.29

Here I assumed that earnings would grow at 5% each year. I kept the same 50% payout ratio and the 15 P/E assumptions throughout. The other 50% of earnings is used to repurchase shares. It should be noted that some of the leftover cash would most definitely be used for reinvestment and short-term liquidity needs; however, I wanted to keep the simplicity of the example to underscore the lasting point. We see that with earnings growing at 5%, the value of the company also grows by 5%; from $1,500 to $2,443. The value from the share repurchases is seen in the way of dividend, EPS and share price growth. Instead of growing by 5%, each category grows by 8.6%. The value of the share buyback is in the way of a multiple factor of growth.

Finally, I have provided an example with both earnings and dividends growing at 10%.

Earnings Grow at 10%            
  Shr Repurch Shares Out Earnings Value Div / Share EPS Share Price
Year 0 0.00 100 $100 $1,500 $0.50 $1.00 $15.00
Year 1 3.33 96.67 $110 $1,650 $0.55 $1.14 $17.07
Year 2 3.33 93.34 $121 $1,815 $0.61 $1.30 $19.45
Year 3 3.32 90.02 $133 $1,997 $0.67 $1.48 $22.18
Year 4 3.30 86.72 $146 $2,196 $0.73 $1.69 $25.33
Year 5 3.27 83.44 $161 $2,416 $0.81 $1.93 $28.95
Year 6 3.24 80.20 $177 $2,657 $0.89 $2.21 $33.13
Year 7 3.20 77.00 $195 $2,923 $0.97 $2.53 $37.96
Year 8 3.16 73.84 $214 $3,215 $1.07 $2.90 $43.54
Year 9 3.11 70.74 $236 $3,537 $1.18 $3.33 $50.00
Year 10 3.05 67.69 $259 $3,891 $1.30 $3.83 $57.48

The same unrealistic, yet illustrative, assumptions are kept in this example. Except, instead of keeping the dividend payout ratio at 50%, we allow the payout ratio to fluctuate keeping the dividend growth in line with earnings growth. This effect is particularly noteworthy. By growing the dividend in line with earnings, we eliminate the multiplicative effect on dividends but keep the effect within the EPS and share price. More specifically, earnings, value and dividends grow at 10%; while EPS and share price grow at 14.4%. It is interesting to see that this causes the dividend payout ratio to fall from 50% to around 33%. In effect by growing dividends in line with earnings and repurchasing shares, a company is strengthening the sustainability of their future dividend payouts.

While these examples are purely illustrative and likely not precisely accurate, there is a lasting realization: Share Repurchases can provide value in a very quantitative manner. Furthermore, if one happens to buy at a more attractive price, say a P/E of 10, or reinvest the dividends, the value effect is compounded.

When I look for an investing opportunity, my first instinct is to look at the company's dividend. Not just the dividend; but the current yield, past growth rates, record of increasing their payout and the overall sustainability. In no way can I tell you what the value of a given security will be in a week, a year or a decade. However, I know that the applicable math determines that I don't have to care what other people are willing to pay for my investments in the future if my ownership stakes remain profitable and rewarding. The second item that I look for is share repurchases. I believe that many people overlook this value adding tool. As we have seen, the underlying attractiveness of the math should not be ignored.

Here are a few examples of dividend growth companies with share buyback programs. Certainly price paid and overall suitability are fundamental for any investor, but a history of increasing their payouts by a rate that far outpaces inflation and repurchasing shares are two of the most fundamental building blocks in my book.

AT&T (T) - Recently announced an authorization to repurchase about 5% of the company's outstanding stock.

Procter & Gamble - Returned $7.0 Billion to shareholders through the repurchase of P&G stock in 2011.

IBM (IBM) - Announced a $7 Billion share-buyback plan boost in April of 2012; has reduced the shares outstanding by a third since 2000. Warren Buffett, 5.5% owner of IBM, beautifully illustrates why a "languishing" stock price would be the best thing to happen to IBM and its share repurchase program in his 2011 Berkshire Hathaway shareholder letter. (Pages 6-7)

Kimberley-Clark (KMB) - Announced in January of 2012 that it expected share repurchases to total between $900 million and $1.1 billion in 2012; roughly 3% of the company.

Target (TGT) - Announced in March of 2012 that it had completed its $10 Billion share repurchase program. Board authorized a new $5 billion repurchase program to be completed in the next 2-3 years.

Of course dividends and share repurchases are just a beginning. It is important to note that overpaying for shares, even in a wonderful business, can hamstring the applicable math. Additionally, not all investors benefit as the company must buy those shares back from someone. It remains, however, that one should not overlook the value of share repurchases.

Disclosure: I am long KO, JNJ, PG, T, IBM.