Implications of Share Buy-Back: The Smart and Not-so-Wise

As investors, we often see two types of share purchases.

One of them involves a director utilising his or her personal money to purchase the shares, which may indicate the company is undervalued or seen as supporting the share price. The shares are kept under the director’s personal account.

The another involves a company utilising its own cash resources to purchase shares from the open market. After it is purchased, the shares go to the company’s treasury share account. This reduces the number of shares outstanding in the stock market.

[Example]

Before any form of transactions:

(Figure 1 – normal scenario)

[New outcomes under different scenario of director’s purchase and share buy-back]

Director’s purchase: he purchased back 1,000 of shares

Share buy-back: the company purchased 1,000 of shares

(Figure 2 – implications for EPS under 2 scenarios)

A director’s purchase or anyone’s purchase of the shares do not affect the shares outstanding. Only a company’s share buy-back does.

In my article, I am going to focus on share buy-backs and how companies could utilise it strategically to add value to its shareholders. Under figure 2, share buy-backs do add value for existing shareholders because each share is entitled to a greater pie of the overall earnings. There is a cost to it, though.

Think about it for a moment. Imagine, your company is worth $100,000 and everything stays the same from 2008 to 2017. Along with the business, there were 100 shareholders and each shareholder owns 1 share. It is easy to derive each shareholder’s share of the business. It is simply taking $100,000 divided by 100 shareholders… you’ll get a figure of $1,000 per shareholder, i.e. with each share being worth $1,000.

Every day, the shares are quoted in the stock market and it fluctuates wildly. It shoots up to $2,000 and it goes all the down to $500 even!

Which path would you choose – if you are management? (net asset value = shareholders’ equity)

[2008] The shares of this business went down to $500. Sensing a great opportunity, you decided to purchase buy 30 shares back, which you paid $15,000. The remaining number of shares were 70 shares and you are left with $85,000 net asset value. Taking $85,000 divided by 70, the new intrinsic value per share is $1,214.28 – higher than the initial amount of $1,000!

[2017] The shares of this business are trading at $1,500. Feeling good about the business, you decided to buy-back 30 shares back. You paid $45,000. The remaining number of shares were 70 and you were left with $55,000 net asset value. Taking $55,000 divided by 70, the new intrinsic value per share is $785.71 – lower than the initial amount of $1,000.

From this, when companies buy back shares from the open market, it has a tangible and real benefit to the remaining shareholders… ONLY when it is purchased at a discount to fair value. The focus lies whether the price paid for each share is reasonable. For the shareholders who sold their shares at $1,500, it was a good deal. For those who sold at $500, unfortunately, they have also transferred their future wealth away to the remaining shareholders.

(Figure 3)

I would be very happy when shares are purchased at discount. You would think management would act rationally. A few days ago, a reader sent me this chart which shows us that the behaviour is the total opposite:

(Figure 4)

Rightfully, we would have expected corporations to repurchase a huge number of shares during a crisis. Yet, in this chart, it shows that during alluring market highs of 2007 – 2008, corporations purchased a significant number of shares. In 2009, when the value of the shares fell, they did not. Most corporations are just following what others are doing. It takes certain courage for a CEO to be unconventional. It makes more sense to buy something when it is cheap, not expensive.

Why then CEOs embark on massive share buy-backs in the wrong timing? The answer lies with this. During the late stages of any economic cycles, profits tend to slow down. Corporates struggle to report higher earnings per share to look good in front of wall street. Many have resorted to borrow debt or use its cash resources to do share buy-back. Some companies that are already doing well might resort to share buy-backs to further boost its earnings per share artificially.

Using NASDAQ-listed The Children’s Place (NASDAQ:PLCE) to illustrate how share buy-backs boost earnings per share:

Cumulatively, from FY2011 to FY2018, the share count dropped by 34.1%.

(Figure 5 – Different Shares Outstanding)

Instantly, you will notice that using a different denominator, the same profits will yield different earnings per share. The effect of reducing the share count by 34.1% boosted the earnings by 51.9% – which is the difference between $4.92 and $3.24. This 51.9% earnings per share growth were purely created out of share buy-backs. This is the power and effect of share buy-back.

There is absolutely nothing wrong with a company’s approach to growing it’s earning per share. As an investor, however, we need to know whether the growth in EPS is driven by share buy-back, real earnings improvement or a combination of both.

Share buy-backs could be used to fund its employee stock options as well. For eg, 10 employees are entitled to 1 share each after hitting certain profit targets for their departments. The company can choose to create new shares (dilutive to existing shareholders) or buy back shares from the market and offer it to employees at a lower price.

Again, is it a smart or not-so-wise move? It depends on the valuations that you have on Children’s Place. Just like what we’ve described over using figure 3… if the management is buying at overvalued prices, the existing shareholders stand to lose out from it.

Moving on, what are the red flags by monitoring transactions?

(Figure 6)

Under scenario B, I happened to see certain companies where the directors are selling very aggressively whereas the company are purchasing shares back equally aggressive, this is not coherent. This may indicate that the company is supporting the share price for the directors to sell out. You should avoid such companies.

When a company performs share buy-back, the management should have a rough idea of how much their shares are worth. When you see a company that is unable or unwilling to buy back shares at a much lower price than a price that they paid before, you should avoid such companies too. It is either they’ve paid too much to purchase their shares earlier or they did not plan for proper use of their cash resources.

These are subjective towards my own views and I am definitely not an expert either.

When USA President Donald Trump signed the tax cuts into law, businesses get to retain a larger portion of profits since the tax rate is amended from 35% to 21%. His former economic advisor, Gary Cohn, wanted the original intention of the tax cuts to encourage companies to spend on capex. To grow one’s business and increase hiring for the economy. Unfortunately, it does seem most of the extra profits had gone into share buy-backs which are propelling up the stock market. We are coming to almost 10 years anniversary since the last crisis happened, will we see a repeat of the same behaviour?

What Happens After Share-Buy Back?

There could be two outcomes.

1. It will be kept as treasury shares and be cancelled off
2. Some of them could resell their treasury shares at open market at a higher price then book in a capital gain on their shares.

Under option 1, this sends a strong signal of confidence about the company’s future prospect. Once shares are cancelled, there is no way a company can sell them. The outstanding shares are reduced permanently.

Under option 2, when the management does that, this could indicate their shares are overvalued. Since they are the insiders, this may cause some panic among existing shareholders. There may be an adverse reaction to the share price but it strengthens the balance sheet by having more cash. A short-term reaction. This reduces the treasury shares portion of the equity and adds back cash to the balance sheet.

Again, these are perceptions by the investors, but perceptions often turn into reality through self-fulfilling prophecy and own actions. However, there are exceptions where despite the company selling their treasury shares, the share price continued to climb.

Summary:

• Share buy-backs are accretive to existing shareholders when it is purchased at undervalued prices.
• Avoid companies where the companies are doing buy-backs while the directors are dumping their shares.
• The conventional approach is to buy back shares towards late cycle to grow your earnings per share while the absolute net profit is stagnant. But it comes at a high cost when the shares are at high valuations.
• Unconventional approach is to buy back shares during a crisis where management can acquire their shares at reasonable prices.

[Bonus] Check these two articles out!

Article 1: The Big and Possibly Dumb Buyback Boom (https://www.bloomberg.com/view/articles/2018-03-06/the-big-and-possibly-dumb-boom-in-corporate-share-buybacks)

Article 2: When Stock Buybacks Are Not a Waste of Money (https://hbr.org/2014/11/when-stock-buybacks-are-not-a-waste-of-money)

PS: I really like the second article which highlighted the late Henry Singleton’s approach. When his shares were trading at high price multiple, he used it as the currency to purchase companies with lower price-multiple. Just think about it, a strong currency used to buy lower currency, you’d get a good deal because you don’t need to issue too many shares for it. When his shares were trading at low price-multiple, he would borrow debt or use organic free cash flow to repurchase his own shares.