The value of share buybacks

Research shows that many companies are wasting their shareholders’ money, by undertaking share buybacks that effectively transfer value from continuing shareholders to selling shareholders. At the very least the research suggests that boards often make ill-judged buyback decisions. Worse still, as stockbrokers Collins Stewart points out, some companies sometimes undertake share buybacks for the wrong reasons.

Share buybacks can be a good thing when a company is sitting on a pile of cash which is surplus to trading requirements and expansion plans. Before the Companies Act 1981, which allowed limited liability companies incorporated in Great Britain to purchase their own shares, such a cash surplus might have been used by the board of directors for grandiose empire-building, such as unsuitable acquisitions. Nowadays, a company can nominate a broker to buy its shares in the stock market. Normally, these shares are then cancelled, boosting EPS.

Take a pause
Share buybacks have an advantage over increasing the dividend because, if a company suddenly finds it has a need for cash and cuts its dividend, the share market would not take this too kindly and would reduce its share price. However, a company can take a pause in its share buyback programme without causing too much negative comment.

It is estimated that in 2007 almost 15% of Europe’s large and mid-cap companies undertook buybacks exceeding 2% of their market capitalisation.

However, recent research by Collins Stewart says that many companies are ignoring the essential valuation criteria that determine whether or not a buyback creates value for a company’s investors. It says companies focus too much on boosting EPS, when the fundamental question should be the price at which shares are repurchased. It also blames advisers for influencing companies to undertake inappropriate buybacks just for the advice fees and the commission.

Collins Stewart says “a substantial number of buybacks are, collectively, destroying billions in shareholder value through ill-judged decisions”. The research found that, in aggregate, there was less than a 50% chance that a share buyback would now lead to a company’s share price outperforming.

The most important principle of buybacks, Collins Stewart argues, is that they earn a return for continuing shareholders, just like any other use of the cash. It follows that buying expensive shares is no more a good idea when companies do it than when an individual investor does it. This does not seem to have stopped many companies from ploughing on regardless.

Undervalued stocks
Previous empirical studies found that buybacks create the most value when the market undervalues the stocks to begin with. But after four years of strong equity markets there have been fewer undervalued stocks available for companies to buy back below intrinsic value – at least until recently, although the apparent reversal of trend could well be wiped out by profit warnings yet to come.

Managements often attempt to ramp up the share price, or other key ratios, for what Warren Buffett has called “unstated ignoble reasons”. Chief of these is to meet their own bonus package targets, where the rewards are big enough to leave no stone unturned. This view is shared by Collins Stewart when it says an emphasis on EPS-based performance hurdles in executive bonuses could create an incentive for boards to sanction share buybacks even when their share price is too high (see 'The Next buyback').

Investor pressure
According to the Financial Times, share buybacks have become increasingly popular in recent years as the expanding economy has strengthened corporate cashflow and boards have bowed to perceived investor pressure to hand back cash. The relatively low level of debt carried by listed companies has also provided scope to take on more leverage and return cash through share buybacks.

One of the reasons given for taking on increased debt to fund a share buyback is that it is more efficient, ie, interest on debt is tax deductible, unlike dividends. However, debt has to be repaid at some time. Furthermore, what gets a company into financial difficulties is not lack of profits, but lack of cash.

To sum up, a board of directors should only authorise a buyback of the company’s shares when:

• The buyback will be paid for with monies surplus to the company’s trading requirements and expansion plans;
• The surplus funds would not be better first used to pay off debts;
• The share buyback will earn a return for continuing shareholders; and
• It is in the best interests of continuing shareholders.

The Next buyback
The management of Next plc have been described as “buyback junkies par excellence” by brokers Collins Stewart, which cites the retailer as an example where share buybacks can put the interests of shareholders and management in direct opposition.

Between 2000 and 2007, the company bought back one-third of its shares creating considerable value for continuing shareholders. Between April and November 2007, however, the company spent £464m buying back around 10% of the shares as the price fell from its peak. As of the end of November,
those shares would have had a market value of £374m – a notional loss of £70m for continuing shareholders, says Collins Stewart.

However, share buybacks in 2006-07 would have increased EPS by more than 4% than if cash had been returned via a special dividend, while buybacks in 2007-08 add 6.6% to EPS. But, as Collins Stewart points out, the board’s annual performance bonus starts to pay out with EPS growth of 5%.

“The executive are in the money even if operating performance is flat,” says Collins Stewart, adding that the top four executives earned an extra £360,000 between them last year as a result of the buybacks.

Useful links
Collins Stewart is at www.collins-stewart.com
Its recent newsletter, Buyback hijack, is at www.csquest.com