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Share buybacks – doing the right thing

20/03/2016

Share buybacks are frequently misunderstood as some sort of share support scheme. They are an alternative or complement to dividends as a way to return capital to shareholders. But they can destroy shareholder value even if they are accretive to earnings per share. Cue conflicts of interest when executive pay is tied to EPS growth.  So buybacks are counter-intuitive. In this Insight we model buybacks at different share prices and present an example of best practice from Next PLC in avoiding inadvertently hurting your own shareholders with an overly aggressive buyback programme, and an alternative to EPS growth for exec remuneration targets. Regardless of the mathematical impact on EPS, it only ever makes sense to buyback shares if they are undervalued and, even then, only if it represents the best use of cash within the broader business context. Drop us an email if you’d like us to assess your business’s cash generation and distribution.

The two ways to return cash to shareholders are via a recurring or special dividend, or share buyback. If the shares are correctly valued, the impact of a dividend or share buyback is identical (before any differences in income tax vs capital gains tax for the shareholder). This is despite a share buyback programme generating higher EPS growth than a dividend programme.  All things being equal (and this isn’t always the case), holding on to surplus cash generating bank interest is not shareholder friendly.

Our worked example below looks at two identical companies, one paying  dividends, the other using the cash to repurchase shares. It can be shown that if the shares are repurchased at fair value, the companies will be identically valued. This looks odd because the company buying back shares has far higher EPS at the end of the period.  This is because the companies have the same absolute profit at year 10, but the buyback company has fewer shares. The difference per share is the present value of dividends paid by the dividend-paying business. So all is equal.

div vs bb worked exampleShares rarely trade at fair value, and unlike our worked example there is no objective measure of fair value for real companies because of the uncertainty of future financial performance.

The below charts show the same worked example, but the left-hand chart assumes shares are repurchased at a 20% discount to fair value over the 10 years, and the right-hand chart a 20% premium.

bb at prem disc chartsIn our example this drives a 19% increase in present fair value of the company when shares are bought back at a 20% discount to fair value. Selling shareholders are penalised but the majority who hold onto the shares benefit from the shares being bought back by the company at below fair value.

In the right hand chart the present fair value drops by 9% because the shares are repurchased too expensively.

What is key here is that there is still EPS accretion from the buyback process even though it is destroying shareholder value. A buyback vs a dividend will always raise EPS, so this is no measure of the effectiveness of a buyback, something that some board remuneration committees fail to appreciate and some executives paid on EPS growth take advantage of. Total Shareholder Return (TSR), being EPS growth plus dividend yield,  is a better approach here than EPS growth for executive remuneration.

Given there is no objective measure of fair value for real companies, how can companies decide, objectively, whether a buyback is the right thing? Simon Wolfson, CEO of Next PLC, has discussed this topic in his annual report CEO statement most years and has a framework he uses to decide whether to buyback shares, and also uses TSR as a performance indicator rather than pure EPS growth.

His measure of the value of a buyback is to look at the EPS growth driven by the reduction in share count, and compare it to the absolute profit growth that would be required to generated the same increase. He then looks at that profit growth and divides it by the cost of the buyback programme to derive an Equivalent Rate of Return (ERR). If the ERR is below the cost-of-capital, or expected return, he pays a special dividend rather than buying back stock. This happened in 2014/15. We show in the Appendix below how this approach can be used to define a maximum buyback share price, above which a cash dividend is better value for shareholders. Applying this approach back to our model doesn’t perfectly determine fair value, because of course fair value cannot be perfectly known in advance, but it does provide an objective framework to avoid overpaying for your own shares.

As the chart at the top of this article shows, share buyback volumes and share indices track each other, suggesting that companies are not being disciplined in repurchasing their shares.

Related links:
Appendix – Oakhall – buyback tools
Next PLC January 2013 annual report
Investor viewpoint (Randeep Grewal) – Watch out for the terminology
Blackrock CEO “We certainly support returning excess cash to shareholders, but not at the expense of value-creating investment”
Druckner Institute on the perils of [short term] shareholder value
T
hanks to HollAnd Advisor’s Great Businesses website where we found the Next PLC example,  and to our friends at Farringdon Capital for their insight on the topic. 

Andrew Griffin spent almost two decades as a technology equity analyst before working in investor relations, corporate development and market intelligence for a UK listed software company. In 2015 he set up Oakhall to provide smart financial analysis and articulation for European public and private companies.