Monday, April 6, 2015

How effective are those share buybacks?

Companies have a few options when it comes to creating shareholder value.  The most important is the ability to improve the underlying operations of the company through growth.  My favorite is through dividends and of course share buybacks are another option.  I want to ignore the dividends for the time being and focus on growth and share buybacks.

When a company is growing and able to buy back shares at a cheap valuation, shareholders win.  You benefit from both the underlying growth of the company and a lower share count.  That's the icing on top of the cake that can lead to out-sized returns over the long haul.   While a decreasing share count is excellent, you now own more of the same company, that's not the be all and end all when it comes to analyzing a share buyback program.

Let's take a look at one of my holdings, Visa.




Just looking at the share count you can tell that Visa has been pretty aggressive in reducing the outstanding shares.  Since the end of FY 2010, Visa's share count has been reduced by a total of 14.61% or 3.87% per year.  That's a pretty impressive total considering it's just a four year stretch.

However, we also need to look at the share buyback in terms of the relationship between net income, earnings per share, and adjusted earnings per share.  The following table outlines how each metric has changed since the end of FY 2010.


Net income has grown at an impressive 16.36% per year over the time period.  Since Visa is growing and buying back shares, earnings per share growth has been supercharged and grown at a 21.05% annualized rate.

Adjusted earnings per share is calculated using the current years net income divided by the original share count.  So 2014's adjusted earnings per share is calculated at $5,438 / 2,956 = $1.84.  By normalizing the earnings per share for the original share count we can now dig a bit deeper into how effective Visa's share buyback has been.

Looking at the cash flow statement we can see that Visa has spent a total of $12.217 billion on share buybacks.  That's shareholder equity value that has been used by management for shareholders.  So have they done a good job with that?  Dividing the $12.217 billion by the original share count of 2.956 billion gives a value of $4.13 per share of equity value used to reduce the share count.  If we subtract the adjusted earnings per share of $1.84 from the earnings per share of $2.15 we get the effect of the share buyback on earnings, in this case that's $0.31.  Management has effectively earned 7.62% on behalf of shareholders with the equity used to reduce share count.  That's a solid return but with a return on equity in the mid to high teens, maybe there's a better use of that capital.

What about another one of my holdings and a buyback king, IBM?


IBM's share count has been reduced by 21.52% since FY 2010 or 5.88% per year.  Net income has declined by 5.12% per year but earnings per share have increased by 0.81%.  Management has spent $48.803 billion on share buybacks or $37.92 per share worth of equity.  With all of that capital that IBM has used to retire shares they've earned a 6.75% return.  That's not bad, but for a company that is having issues growing the actual net income I could think of better uses for that capital.  Specifically reinvesting in the business or even higher dividends.  That's the downside to looking at just the earnings per share numbers without also looking at the net income figures.  In IBM's case, net income has decreased by over 5% per year but the headline earnings per share number has shown a modest improvement.  The buyback has helped to mask some of the issues with IBM's transition away from a hardware company.

One last company I want to look at is Pepsico.


Pepsi's share count has been reduced by 5.39% total since the end of FY 2010 which is good for a 1.38% annual decrease.  Net income has been pretty stagnant with just 0.75% annualized growth but the headline earnings per share number increased 2.16% per year.  You can see that through the share buyback program Pepsico was able to increase earnings per share by $0.23 in FY 2014 compared to the adjusted earnings per share number of $4.04.  Management spent $13.721 billion dollars to retire those shares or $8.50 per share in equity value.  Management has effectively been able to earn $0.23 / $8.50 = 2.70% on the capital used for buybacks.

When a company decides to use shareholder funds to buy back shares there's an inherent trust that the company feels the stock price has the company undervalued.  If that's the case then the shareholders that stay the course win because the company is buying back shares when they're cheap and get the added boost to earnings per share.  But it's important to not take the headline numbers of earnings per share or reduced share count lightly.  A little further analysis can reveal quite a bit about whether management is using your capital prudently.

Have you ever looked at the value of the share buyback programs for the companies you own?  Any companies that you know of that have been doing an excellent job with share buybacks?

21 comments:

  1. Visa's buybacks have been impressive but the current valuation is at nosebleed level. I prefer (and hold) AXP in the current environment.

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    1. FV,

      V has done a pretty solid job with the buybacks but at current valuations I really hope they aren't making any moves. A better opportunity will eventually come.

      Thanks for stopping by!

      Delete
  2. Great analysis, JC. I have been public with my opposition to the whole buyback method of returning cash to shareholders. I think most companies do it badly and the capital is better of elsewhere - either special dividends or invested. Buybacks have just become a tool to help the management mask problems - as you have illustrated with IBM. If history is any indication, companies are not the best at timing the buybacks well - they seldom buy when its cheap.

    R2R

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    1. R2R,

      I much prefer either reinvestment into the business, higher regular dividends, or special dividends. I don't expect higher regular dividends because once a dividend level is reached shareholders are going to expect that in the future, whereas very few bat an eye at a share buyback program being suspended.

      Thanks for stopping by!

      Delete
  3. JC,

    Great write-up with examples to show the effect of share re-purchase programs. Rarely do we see people, especially personal finance/FI bloggers, taking the time to dig in and actually explain the mechanism of share buybacks. This is a great way to show the effect from 3 different companies.

    I agree with Roadmap2Retire in that shareholder equity can be better spent via special dividends or other investments, but they are often used to mask issues by propping up EPS values.

    Great article!

    -Dividend Odyssey

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    1. DO,

      There's better uses for the capital than share buybacks, but I don't expect that to change anytime soon. There's a lot of compensation tied to stock options nowadays so at a minimum companies will need to buyback at least the amount of shares to offset the dilution or else other shareholders will get mad.

      If I had my way, compensation tied to options would be reduced and the regular dividends would be higher. If a company wanted more flexibility then they could do special dividends to keep themselves from overcommiting to the dividend. Share buybacks being reduced or stopped aren't really a concern for shareholders, but if the dividend is cut then there's hell to pay.

      Thanks for stopping by!

      Delete
  4. Good write up JC,

    T is another interesting stock buyback. Instead of improving or hiding eps, T used stock buybacks to lower its dividend payments. KO is an example of bad stock buybacks. They buy back stock and then reissue the same stock. I have no idea what KO is doing.

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    1. Broke Dividend Investor,

      I'll have to check out how T has done with their buybacks but I have a feeling the overall numbers won't be that pretty. That's a similar method to what PM had been doing these last few years. Borrow money at 2-3% to retire shares that cost you 4-5%. That can work but it's important to look at what the real growth of the company is as well.

      Thanks for stopping by!

      Delete
  5. Very nice write up on share buy backs. I would rather just get dividend increases! I am also taking a look at PEP even though it is a little pricey at the moment. I love having them as a core holding in my portfolio and should perform above average in the long term. How do you feel about them at these prices?

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    1. Mongrel,

      I'd much rather have higher regular dividends or special dividends but I don't think we'll ever see that. Too much executive compensation is tied to options which means the best thing for them is to increase EPS through any means necessary.

      It's been a while since I've taken a deeper look at PEP, thanks for the homework over the next few weeks. I definitely consider it a core holding and love the drink and snacks combo. I'd say shares are most likely on the high end of their valuation but probably aren't at grossly overvalued levels. If you have capital ready to deploy and want a defensive holding then PEP is probably a decent option currently.

      Thanks for stopping by!

      Delete
  6. JC,

    I am not a huge fan of buybacks just because of they are actually implemented and carried out. It feels like buybacks announcements are made at a time of company strength with regard to their share price, and not the opposite (Buffett being the famous exception) which obviously is the WORST time to buy back the shares. Also, it seems that when you actually look at the buy back ratio to options given there is a disconnect. If you are buying back 100,000 shares but granting 150,000 shares in the form of options you aren't really doing much!

    On paper they are fantastic, but I am always skeptical when I see the announcements.

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    1. Evan,

      Couldn't agree more. It seems like the SoP is when the stock market is churning higher and the economy is running well companies like to announce share buybacks. Unfortunately that's also when the companies are most likely to be richly valued.

      There's a lot to look into when it comes to share buybacks. More often than not there's a huge required outlay just to offset the effect of dilution from options. That's really hurting shareholders from a creating value perspective. If buybacks are done right then everyone wins.

      Thanks for stopping by!

      Delete
  7. Thanks for a great article! I'm not too concerned about buybacks, provided they're done in the right way (i.e. not to hide fundamental issues). Buybacks are beneficial to shareholders in that they own a slightly "larger piece of the pie". It is tax efficient, too. Buybacks properly done are beneficial to companies, too. With fewer outstanding shares, the total cost of dividend payments are reduced.

    Of course, I prefer dividends as a way for companies to return shareholder value. But buybacks are not all bad.

    Cheers
    FerdiS

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    1. Ferdi,

      Buybacks are more tax efficient than dividends for sure, but I think the aren't done as well as they could be. A lot of the buyback capital goes to offset the effects of dilution from options.

      If I had my choice executive compensation wouldn't be through options thus reducing the issue of dilution. That way buybacks would actually go to retiring shares. I guess I need to make a follow up article because I just thought of another thing to look at regarding share buybacks/options/dilution.

      Thanks for stopping by!

      Delete
  8. Buybacks were very effective so far, just look at the market! Not only it created a good value for the shareholders but it propped this market to the new ATH (all time highs).

    I am completely fine with this.

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    1. Martin,

      While buybacks will add to EPS and "create" value sometimes it's not in the best interest of the shareholders. If a company has projects they can invest in that will provide better returns than the share buyback then that should be the route they take. At least in my opinion.

      Thanks for stopping by!

      Delete
  9. Great analysis JC. IBM is a very good example of a company trying to mask the income decline by using buybacks. This article helps us to analyze the EPS/Income/Buyback numbers more closely.
    Thanks for sharing.

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    1. DGJ,

      IBM has definitely been using buybacks to help offset the underlying issues regarding revenue and earnings. I think it's important to look at the actual effectiveness of the buybacks because they are definitely "en vogue". Sometimes they aren't as good as they seem from the headline.

      Thanks for stopping by!

      Delete
  10. Completely agree with your thesis that there are much better ways to create shareholder value. It seems like a game of 'they did it and so should we' when really most of the shareholders probably feel like we do. I don't think this trend was happening as frequently in the last century which is pretty interesting, I wonder when and if the big guys will wake up and realize there are much better ways to grow. Thanks for sharing, I really liked this post :)

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    1. Ryan,

      I'd prefer to see more dividends, special dividends, or reinvestment into the business but buybacks aren't going anywhere. Buybacks are very short-term oriented because you see the benefits to the EPS immediately. With so much compensation based on short-term metrics we need the incentive plans to change to a long-term outlook to see better use of capital.

      I've got another post on buybacks in the works so stay tuned!

      Thanks for stopping by!

      Delete
  11. I sure am hoping the share buyback that GE is proposing becomes very effective. Only time will tell. Nice article.

    Keep cranking,

    Robert the DividendDreamer

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