Thinking about share buybacks can make your head hurt. The act of a company buying its own shares can resemble art created by M.C. Escher. Because of this, there are misconceptions about what buybacks actually accomplish. Do they slow economic growth? Do they inflate share prices? Are they some form of evil financial engineering?
Before we get into buybacks specifically, let’s do a little background work.
What’s the purpose of a corporation? The answer likely depends on your perspective. If you’re a customer, the answer may be, “To sell me things”. If you’re an employee, the answer may be, “To pay me”. If you’re a supplier, the answer may be, “To buy my stuff”. If you’re a lawyer, the answer may be, “To limit the liabilities of the owners”. And if you’re one of those owners, the answer may be, “To generate an acceptable return on my investment”.
We’re primarily investors, so we’ll write this commentary from the perspective of an owner. If you would like the perspective of a customer, we would suggest perusing this list of Amazon.com customer reviews that includes these incredible assessments of a t-shirt:
Why Own a Company?
An owner initially seeds a company with capital. Hopefully, the company will grow and thrive such that it generates profits. Ideally, these annual profits will be large enough such that they represent a substantial percentage of the owner’s original investment. Roughly speaking, the average U.S. company has generated a return on capital of 10% annually. Therefore, a company that generates annual profits representing more than 10% of invested capital could be considered a good company, and one that generates less than 10% could be considered a poor company.
Injections of capital into a company aren’t limited to when it is founded. At any point in time, either debt or equity capital can be invested. This debt or equity has a cost associated with it: either in the form of interest for lenders, or expected profits for shareholders.
The blended rate that lenders and shareholders expect to be paid in return for investing in the company is called the “weighted average cost of capital” or “WACC”. For instance, if a company was seeded with a 50/50 mix of debt and equity, with the cost of the debt being 7% and the cost of the equity being 15%, the company’s WACC would be 11% (½ × 7% + ½ × 15% = 11%).1
Management teams establish a “hurdle rate” for new projects. That is, for a new project to be approved, it must have estimated returns at least as high as the hurdle rate. The hurdle rate should be above the WACC; if the project generates a return that is equal to the WACC, it is simply matching its cost of financing and there is nothing left over to increase shareholder value. If the project generates a return that is below its WACC, it is destroying shareholder value (and, if the returns fall low enough, the company will find itself in a position where it can’t pay the interest on its loans).
To recap: investors provide companies with capital. In exchange, investors expect to be paid at least the WACC. To fund the WACC, the company aims to invest in projects that generate returns above management’s hurdle rate. If the projects do end up returning more than the WACC, the excess cash flow goes to equity holders. If the projects end up returning less than the WACC, the cash flow deficit comes out of the equity holders’ share.
Nowhere to Spend Money
Now, what should management do if the company is sitting on a pile of cash, but they can’t identify any potential projects that exceed their hurdle rate requirements? From our point of view the answer is simple: it’s not management’s cash, so they should give it back to shareholders. And there are two ways to give the money back: via dividends or via share buybacks.
Dividends are straightforward: all equity holders get paid cash by the company. However, a limitation with dividends is that investors expect the payout to continue indefinitely. Buybacks, however, can be stopped and started as management sees fit. As the following chart shows, today’s management teams in the U.S. definitely see fit.
What are the implications of a projected $1 trillion in buybacks in 2018? As the previous discussion suggests, one possible implication is that companies don’t have a lot of high-return projects into which they can deploy investor capital. This means that, collectively, companies aren’t investing in things like buildings and machinery – things that increase the overall economy’s productivity.
Another frequently-cited implication is that these buybacks are contributing to the recent bull market (as many observers have opined). This cynical view is that management uses buybacks just to boost share prices in the short-run. This view has become especially prevalent since tech companies have accounted for 40% of recent buyback activity. But, do buybacks really boost share prices?
Buybacks aren’t Magic
From a fundamental basis, the answer is “no”; buybacks don’t boost share prices. Buybacks do result in more demand for buying shares in the market. And, yes, all else equal, share prices do rise when there are more buyers than sellers. But all else is not equal in the case of buybacks: every dollar used to buyback a share is exactly offset by decreasing the value of the company’s assets by a dollar. A share is simply a claim on the company’s assets. During a buyback, the number of claims (shares) are reduced, but so are the assets (cash), by an equal amount. There is no magical way to increase the total value of the company simply by both reducing the value of the company’s assets and reducing the number of claims on the same assets.
Counterpoint: a bird in the hand is worth two in the bush. A study has shown that markets value cash held by poorly-run companies at less than 88¢ on the dollar. Why is this cash valued so low? Back to the preceding discussion about hurdle rates: poorly-run companies invest shareholder capital in projects that generate returns below the company’s WACC. This behaviour destroys shareholder value and makes $1.00 in management’s hands worth less than $1.00 in shareholder’s hands. If a company being valued like this was to buyback shares then, yes, that would increase the market value of the remaining shares. It shows that management is willing to turn 88¢ dollars into 100¢ dollars; thus, the market would be foolish to value the company’s remaining dollars at $0.88.
Additionally, if the market is valuing any of the company’s other assets – including the discounted value of its future cash flows – below their intrinsic values, it makes sense for management to initiate buybacks. You can think of this as the company simply acting as a savvy investor by buying shares for less than they’re worth.
Unfortunately, there are only, like, three-and-a-half CEOs on the face of the earth who don’t think their shares are perpetually undervalued. That’s why so many companies do buybacks during bull markets when their shares are likely overvalued. One notable exception is Warren Buffett. He has a policy of not buying back Berkshire Hathaway (BRK.A-NYSE) shares unless they are trading for less than his estimate of the company’s intrinsic value (which he previously stated was 1.2x book value).
Give it Back
Buybacks aren’t a magical way to pump up a company’s share price. While we have no doubt that there are management teams out there who do think buybacks will boost the company’s share price, we believe those individuals are in the minority. In fact, a study has shown that most management teams actually do view buybacks as a way to distribute excess cash.
From our point of view, we wish more management teams would initiate buybacks or dividends. Instead, many are focused on empire building; i.e.: using cash to undertake expensive acquisitions that destroy shareholder value to simply make the company bigger. Many of these same CEOs lose sight of the fact that the company’s cash doesn’t belong to them – it belongs to shareholders. If management can’t find a high-return use for this cash, it should give the money back to its rightful owners. After all, what’s the point of owning a company if it’s only going to take your money and never give any back?
1Tax rates also have an impact on the WACC calcuation, but we are ignoring that fact because it doesn’t add anything to this discussion. It would probably just bore you.