Share buybacks are a dime a gazillion these days, and investors see them as an unalloyed benefit. They most assuredly are not. In fact, they can be terrific, lousy, or neutral.
As the hard-headed investor you most certainly are, you want only one thing from a buyback, put perfectly by the CFO of Luminent Mortgage Capital (LUM) during the company’s most recent earnings conference call:
[W]e want to make sure that we are repurchasing stock at levels when the return on equity from doing that is competitive and hopefully meaningfully higher than the return on equities that we can obtain from other investments that we are looking at.
So simple, yet so rare.
Good buybacks are “an investment of capital for greater return than alternative investments,” and they are most definitely “opportunistic”—when the price is right. Bad reasons are if buybacks are used to reduce or mask the effect of sharecount increases from options grants, to show “confidence in our company” alone, etc. These are PR and spin motives that should make you reach for your wallet or purse.
The most patronizing and absurd reason is “to return capital to shareholders.” Completely bogus. If that’s the goal, why should management decide that shareholders must invest their own cash in this company’s stock? Enjoying reduced dividend taxes today in the U.S., we shareholders could take the money and decide what investment we want to make. Unless there is a sound reason to invest shareholder cash in company shares, management should instead pay a dividend and let owners decide what to buy with our own money.
As shareholders—company owners—we should all want only one thing from management: To invest our shareholder capital so that over time it earns a higher return that from any other use of that capital.
While there is no perfect measure of management’s ability to do this, returns on assets, equity, capital and invested capital come close. They all come back to the inalienable truth: If you repurchase a share, it better be buying something that will give us as shareholders a better return than building a factory, hiring staff, increasing research and development, paying down debt, declaring a dividend, or leaving it in the bank where at least it wouldn’t be spent on perks for execs!
Repeat after me: “Investing shareholder capital in a buyback must be better than all the alternatives.” Period.
Since management will rarely express itself as well as Luminent’s, you must exercise your critical faculties. Think like a buyer of the company. What price would you pay to purchase it? Savvy individual investors, private equity funds, public company suitors, and investment banks all perform a discounted cash flow analysis, employing a discount rate, and come up with the net present value of all future cash flows. They employ other methods too, such as sum-of-the parts valuation, book value, and so on, but all aim for the same goal, which is to pay less than for this business than its value such that there is a chance of earning a fair return on the investment.
Ditto buybacks. If the net present value of discounted future (free) cash flows per share, which I’ll call intrinsic value, or IV, is higher than the share price, we’re at the starting line. That’s not the easiest to determine, because the future is inherently unpredictable, and growth is the most uncertain element of future business estimates.
Still, just because something is hard doesn’t mean we don’t do it. As hard-headed investors, we relish the challenge because we know that what others are too lazy to do can bring us rewards.
How to perform a DCF is a subject of books and articles, but any online search will get you free calculators. However, you generally need to find the free cash flow numbers yourself, because online data services are notoriously good at the general and bad at the specific footnotes and small print of company filings. Plus, their definition of free cash flow does not correspond to what I calculate for every company I consider and with each quarterly report: The three forms of true, structural and maintenance free cash flow.
But once you do have free cash flow and your IV, it’s straightforward. Let’s say you calculate that a reasonable buyer would pay $20 a share for a company. With an IV of $20, assume that shares sell for $16. A buyback offers a theoretical return of $4 or 25%. That in itself is neither good nor bad, because a 25% return over a year is joyous while 25% over five years is a yawner and over 10 probably criminal, plus it must be measured against the potential return from alternative investments.
But depending on catalysts that would determine a time period, it’s pretty hard to imagine an investment for most companies that would return 25% in the nearer term. Yes, it’s tough and an art, because management generally doesn’t know with any certainty the return on any investment except commercial paper, T-bills, and money market accounts. That’s why we pay them the big bucks.
One more thing: If your company pays a dividend, remember that a buyback earns not only the theoretical discount from IV, but also the return of the entire future dividend stream for those shares. So there are cases where a buyback at below IV with the dividend retirement kicker can be hugely beneficial to us owners, provided that the dividend policy is sound to begin with.
In sum, good buybacks are at prices below IV, offer a better potential return than alternative investments, and are opportunistic. Bad buybacks are at any price to return capital to shareholders without more reasons, keep the sharecount down where option grants inflate, and worse.
Applying the criteria here, we find that good buybacks come from Luminent (LUM), Assurant (NYSE:AIZ), Key Technology (NASDAQ:KTEC), and The Meridian Resource Company (TMR), for example, while bad buybacks have come for a long time from Genentech (Private:DNA), NVR (NYSE:NVR), United Health Group (NYSE:UNH), and others, to name a few.
Next time you see “buyback,” don’t just jump at the pretty word. Be critical. Buybacks are entirely neutral and may range from a great to dreadful use of your shareholder money.