Finance is complex.
Many writers, economists, and advisors have tried to simplify it with catch-all rules like "leverage is bad", "buybacks are shareholder friendly", and "housing is a terrible investment" but ultimately, the world is much more nuanced than that. Leverage is bad in one situation, but great in another. Buybacks are great for one company, but horrible for another. Housing was a horrible investment in 2006 and a great investment in 2011.
In the world of business, everything is constantly changing. All the simplistic rules cast in stone will eventually get shattered. And there's an underlying logic to why this happens. When the crowd drifts overwhelming in one direction, opportunities open up in the other direction. If investors hate housing, then it's likely the returns will push upwards eventually making it a very attractive investment.
Share buybacks have become one of the more controversial issues in finance. Many investors love them and perceive them as "shareholder friendly." Conversely, many hate them and view them as poorly timed. It's become a hot topic recently with a surge in buybacks at major US corporations.
I'm not here to take the simple path. Like most things in finance, the value of share buybacks depends on the circumstances surrounding the buyback. Many companies have used buybacks to great advantage. Others have used them to shareholders' detriment.
Intrinsic Value and Buybacks
On a basic level, a company is creating value when it buys back shares below their intrinsic value. Conversely, it destroys value when it buys back shares above their intrinsic value. This is simple enough, but companies very rarely view buybacks in these terms.
Unfortunately, share buybacks are more often value destroying than value creating. There are a host of reasons for this. Most companies have no coherent rationale or philosophy on when to buy back shares. Rather, share buybacks are the default option when the companies have a lot of free cash flows and can't find anywhere else to put the money.
The problem is that share buybacks are often a poor investment for the exact same reasons that internal capital expenditures might be. Companies have more difficulty finding good investments when asset prices are high and returns on investment ["ROIs"] fall to subpar levels. With a dearth of internal projects meeting the cost of capital, companies turn to buybacks. Yet, it's exactly those periods when stock prices are likely to be inflated, as well. In essence, companies are merely exchanging one form of malinvestment for another.
The Mathematics of Value Creation and Destruction
Let's take a look at how buybacks can both create and destroy value. I've created a mathematical model for a company that we'll call "XYZ Corporation." With this, I'll show how the prices companies pay for their own share impact shareholder value.
You can see the stats for our company in the chart below. The major points are that it has free cash flows of $6.5 billion and the intrinsic value of its stock is $30.
Remember that the intrinsic value of a company is its true value based on its assets and cash flows. This differs from its market price, which is based upon the price of its stock.
In order to model this out, first we'll need to set up a base-case scenario showing the free cash flow growth over the next five years. For simplicity sake, we'll assume that the enterprise value of the company is always 16.9 times free cash flows. We'll also assume the company pays out 25% of its free cash flows in dividends. You can see the base-case financial model below.
Next, let's take a look at a host of different situations for the stock price. We know the intrinsic value of the stock is $30, but the market value of the stock can vary significantly based upon the market's contemporary perception. On the low end, we have a "Depressed" market with the stock selling 67% below its intrinsic value at $10. On the high end, we have a "Bubble" market with the stock selling 233% above its intrinsic value at $100.
In the chart above, we assume that the stock will return to its intrinsic value in 5 years. Based on this, you can see the expected returns. If the stock sold at the "Depressed" price of $10, then it would be expected to generate a 47.4% annual return once the dividend is factored in. That's spectacular and it would certainly be a great situation to buy.
On the other end, we have the "Very Expensive" and "Bubble" scenarios. In the "Very Expensive" scenario, the stock sells for $50 and has an expected five-year annual return of -1.7% (including the dividends). In the "Bubble" scenario, the stock is expected to lose 15.6% annually for the five year period.
Control Scenario: Dividend Payout
Before we test a few different buyback scenarios, first we need to establish a control scenario. This will be a scenario where XYZ Corporation pays out dividends. For our scenarios, we'll assume that the company allocates 25% of its free cash flows to either dividends ("Dividend Payout Scenario") or to stock repurchases.
The "Dividend Payout" scenario is mapped out below. For simplicity's sake, we'll assume the dividends can be re-invested in the S&P 500 for an 11.6% annual return. Using that, we can calculate a "future value" for the dividend stream for the next five years.
You might ask why "11.6%"? This was mostly to isolate variables in the model. This would make the S&P 500 expected growth nearly identical to our hypothetical company, XYZ Corporation. 11.6% might not be realistic based upon the market conditions, but I'm setting it at this level to make it an effective control. In other words, these scenarios assume the stock for XYZ Corporation is overvalued, while the overall market is not.
Let's move onto the scenarios!
Three Scenarios: Depressed, Normal, and Overvalued
I've created three different buyback scenarios. The first is the "Depressed" scenario. This scenario assumes that the stock for XYZ Corporation is unfairly beaten down and sells below its intrinsic value for most of this five year period, before finally hitting its intrinsic value at the end of the fifth year. You can see the model below.
In the "Depressed" price scenario, the intrinsic value of XYZ's stock starts at $30 in Year 0 and finishes at $64.73 in Year 5. This is compared to an expected value of $50.15 in the control "Dividend Payout" scenario. This intrinsic value improved dramatically as a result of the company buying its own undervalued stock (with a very high ROI) for years.
Next, let's look at the "Normal" scenario. This scenario assumes that the company purchases its own stock at prices that are relatively close to the intrinsic value over the five-year period. This scenario is really just meant to establish that there's not much of a difference between paying dividends and repurchasing shares from an economic perspective. However, it's worth noting that there are tax advantages to buybacks over dividends, so in reality, one could argue this scenario is superior.
You can see in the model above that there's very little difference between the results of the "Normal" scenario and the control "Dividend Payout" scenario. The only real difference is that I didn't factor in the 23% tax rate that many investors would have to pay on the dividends; whereas share buybacks would allow investors the option to delay paying taxes on their gains.
Finally, let's move onto the "Overvalued" scenario, where company buys back shares at inflated prices. You can see the analysis in the chart below. In this case, the intrinsic value of the stock falls to $45.45, about 10% short of the "Dividend Payout" scenario.
For this scenario, shareholders end up worse off than if the company had merely paid out dividends. The "Dividend Payout" scenario provides a future value about 10% higher than the "Overvalued" buyback scenario.
Here's a final summation of all four scenarios:
This provides the clear mathematical case for value creation and destruction in share buybacks. When a company purchases its own stock below the intrinsic value, it creates value. When a company purchases its own stock above the intrinsic value, it destroys value. There are other factors that can come into play, such as tax benefits, but this principle generally holds true.
My model was created based upon the assumption that XYZ Corporation's stock was independent of the overall market. I did this in order to isolate the impact of buybacks on an individual stock. In the real world, things can be more complex.
For instance, in a depressed market, the S&P 500 index might be 50% undervalued, while XYZ Corporation's stock could only be 20% undervalued. Moreover, XYZ Corporation may find itself with very attractive growth opportunities with depressed prices. Therefore, even in a depressed price scenario, it's not automatically a given that share repurchases are the best use for corporate cash.
Conversely, one might argue that in an inflated market environment, buybacks still might be a more attractive investment than the alternative of paying out dividends or sitting on cash. I'm not persuaded by this argument as an investor, as I'd always prefer to have the cash, but mathematically speaking, you can make a case here.
Finally, I'll reiterate that there is some value to the tax delay effects of share buybacks (versus dividends), but it's more difficult to model those out since they can vary significantly for every investor.
The model showcased in this article shows why share buybacks can be either good or bad. Companies buying their own stock at subdued prices are generally creating value for shareholders. Companies repurchasing shares at inflated prices are generally destroying value.
Much research on this issue has shown that companies are more likely to conduct buybacks near market peaks. This suggests that companies don't analyze buybacks with the same methodology that they might analyze internal capital expenditures. Rather, buybacks become a "default option" when companies can't find other places to invest. Hence, in many cases, a large share repurchase program may very well be a loud signal that a company has weak growth prospects moving forward.
I'm not here to argue in favor or in opposition to buybacks. Instead, I'd advocate that investors analyze buybacks in the context of the market for the company's stock, the overall market environment, the intrinsic value of the company, and the company's own internal growth opportunities (or lack thereof).
Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.
The author wrote this article themselves, and it expresses their own opinions. The author is not receiving compensation for it (other than from Seeking Alpha). The author has no business relationship with any company whose stock is mentioned in this article.