Monday, April 02, 2007

Buybacks Can Reduce EPS and Still Add Value To Firm Shareholders

As noted in an earlier post titled, Stock Buybacks and Dividends Remain Strong, companies have returned a large amount of funds to shareholders in either dividends or stock buybacks. It is important to note that buybacks can reduce EPS, but still add value to remaining shareholders. An article titled "Clear Thinking about Share Repurchase", dated January 10, 2006 by Michael Mauboussin, of Legg Mason Capital Management, provides analysis on how to evaluate share repurchases. One excerpt of the article notes:
"Corporate America is in an unusual position today: even after returning a record one-half trillion dollars to shareholders in 2005, companies remain flush. Cash balances are high, debt levels are low, and free cash flow has never been stronger. Delivering superior shareholder returns in upcoming years may require companies to show the same savviness in capital markets as they do in product markets.

How did we get to this situation? The events of this century’s first six years encouraged companies to focus internally, leading to today’s financial position. These include a brutal three year bear market in equities (2000-2002), a number of high-profile corporate scandals, terrorism, a tight U.S. presidential election, heightened perceived geopolitical risk, a recession, and increased regulation. Companies responded by honing their operations, limiting capital spending,hiring sparingly, and hoarding capital. A recent report noted that companies in major economies went from using over $500 billion in capital to fund their operations in 2000 to generating close to $600 billion in free cash flow in 2004, nearly a $1.1 trillion swing in just four years."
The reason an investor values corporate actions around dividends as more important is because of the longer term commitment a company makes regarding future dividend payments. Mauboussin's strategy article notes corporate executives view dividends and buybacks differently.
"Similarly, executives deem buybacks much more flexible than dividends, reinforcing the sense that dividends are a quasi-contract while buybacks are more discretionary (emphasis added). Finally, even though corporate finance relies heavily on the role of taxes in judging the relative virtue of dividends versus buybacks, surveys of executives suggest taxes are a second-order concern in setting payout policy."
Mauboussin goes on to note:
"a recent study suggests a number of repurchase programs are announced with the intention of misleading investors. The researchers focus on companies that aggressively deploy discretionary tools—a means to manipulate earnings—and find the companies suffer from poor operating performance over the long term. The analysis suggests these companies announce buybacks to boost the stock price in the short term. This risk adds ambiguity to the buyback signal, especially for open market programs."
One last point to highlight, and highlighted by Mauboussin is buybacks that result in a reduction in earnings per share can still add value for ongoing shareholders:
"earnings per share accretion or dilution has nothing to do with whether a buyback makes economic sense. The relationship between price and expected value dictates a stock buyback's economic merits...Nevertheless, managements persist in their efforts to maximize earnings per share—sometimes, we will see, at the expense of maximizing value. Why? First, they often believe the investment community mechanically and uncritically applies a multiple to current earnings to establish value. (As disturbing, many investors believe this, as well.) Second, many executive compensation schemes are partially tied to earnings targets.

The EPS management motivation has no sound financial basis. Whether a buyback program increases or decreases earnings per share is a function of the price/earnings multiple and either the company’s forgone after-tax interest income or the after-tax cost of new debt the company uses to finance the buyback. More concretely, when the inverse of the price/earnings multiple—often called the earnings yield—is higher than the after-tax interest rate, a buyback adds to earnings per share. When the earnings yield is less than the after-tax interest rate, a buyback reduces earnings per share. The relationship between the earnings yield and the after-tax interest rate has little or nothing to say about value."

Clear Thinking about Share Repurchase
Legg Mason Capital Management
By: Michael J. Mauboussin
January 10,2006

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