Tag Archives: NET PROFIT TEST

The Mechanics of Stock Buybacks

Conclusion: From the Shareholders perspective most Stock Buybacks produce little benefit when compared to investing the same funds in the company. They produce a onetime gain in Earnings per Share (usually small) but contribute nothing to the growth of the Net Profit or Market Capitalization. If a company is truly unable to successfully invest the Buyback funds in its business, it would be much better for the majority of shareholders to receive a Special Dividend.

For the twelve months ending September 2016, total share buybacks were close to $600 billion for the S&P 500 companies. This is an enormous amount of money being 66% of the earnings and only slightly less than Fixed Capital Expenditures in the same period. The average buyback program resulted in a “buyback yield” of just shy of 3% [1] . This resulted in a very modest annual decline in the shares outstanding which led to an equally modest one time gain in Earnings per Share for the Shareholders, i.e. the vast majority who did not sell their shares.

Because Buybacks and Dividend Yield are considered to be returns to the Shareholder they tend to be lumped together in statements like the “Total Shareholder Yield is currently close to 5% comprised of a 2% dividend yield and a 3% buyback yield”.

“Buyback yield” is very misleading. As the source of funds for Buybacks is operating cash, it should be first and foremost compared to what they would have achieved if invested.
A 3% “buyback yield” is greatly inferior to investing in the company’s business, acquisitions, or even a Special Dividend which would be shared by all Shareholders in hard dollars as opposed the soft dollar benefit attributable to fewer shares.
Here is an example of a typical S&P 500 equity. It has a market cap of $15 billion; its shares are at 15x earnings and it buys back 3% of its outstanding shares. This is compared to a hypothetical but very conservative Investment producing 3% in the 1st year, 8% in the 2nd and 10% thereafter. (This analysis is independent of the underlying profitability of the company.)

feb7-chart1

The share purchase of 3% of the float produces a 3.5% pop in the EPS on day one.  Annualized that is 3.5% in the first year, 1.7% per annum in the second and so on declining each year.  By the second year, the Investment produces a higher return.  By year 8, the Investment led to a Net Profit of $985m which is almost double the first year’s investment while the Buyback produced zero contribution to Net Profit.

Were the stock price reduced by half and the Buyback amount kept the same you would get the following result.

feb7-chart2

The original gain in EPS is increased to 7% but it soon pales by comparison to the Investment.

Using the original price of $15 and twice the buyback funds ($1,000m), the result would be the same as in the previous example but the dollar gain in the Net Profit from Investing would double as twice the funds were used.

feb7-chart3

These hypothetical examples illustrate the mechanics of stock buybacks.  Now let us look at two actual examples.

The first is Apple as it is listed as the most aggressive in terms of dollar amount of funds spent on buybacks in the last 12 months.[2]

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Despite Apple having spent the over $30 billion, it confirms the disadvantages of Buybacks compared to Investments.  In this case we used the average Return on Capital that they earned from 2009-15.

Now let us look at one of the most aggressive buyback programs in terms of the percentage of stock that was bought.  Corning Inc. purchased over 20% of their outstanding shares in the last 12 months [3] which produces an initial gain of 27% in EPS on day one.

feb7-chart5

However, even this aggressive program fails by beat the Investment after year three even though Corning’s Return on Capital is only averages at 10.3% over the 7 years. This illustrates that even massive amounts of buybacks can’t change the fundamental disadvantage compared to investing.

One of the reasons that investors are not more critical of management for stock buyback programs may be because, by doing it year after year, it creates the illusion that it is compounding.  As shown here, each year’s transactions is still the equivalent of getting simple interest.

The proof of this is found in the Net Profit Test[4]. It answers the question:

What is the Required Rate of return on an Investment of the funds, that would grow the Net Profit at the same rate that the EPS grew due to fewer shares.  Like Apple, the answer is surprisingly low in most instances.  We analyzed 30 stocks[5] whose buyback programs resulted in a median decline of 25% of their outstanding shares from 2008 to 2015. The median Required Return would have been only 4.9%.

The median growth rate for their EPS was 7.7% pa while the Net Profit grew only at 2.4%.  Instead, by investing at less than 5%, the Net Profit would have been 42% higher in the 7th year. Over the seven years the cumulative gain in Net Profit would have been 1.8x the original investment.

It makes no sense to put the growth of Earnings per Share ahead of the growth of Net Profit and as a result, the growth of the Market Capitalization.

A Simple Test to Dispel the Illusion Behind Stock Buybacks

Fair Game

By GRETCHEN MORGENSON AUG. 12, 2016

“Mr. Colby has developed an illuminating analysis that identifies a crucial difference between many truly successful companies and their underperforming counterparts. The exercise highlights the growth mirage that buybacks have on earnings-per-share measures. In addition, it shows that returns on investment need not be that large for a company to generate growth rates exceeding the evanescent earnings-per-share gains associated with buybacks.”

Footnotes

1.Factset Buyback Quarterly December 19, 2016. Defined as the buyback funds divided by the market capitalization.
2.Factset
3.Factset
4.The Net Profit Test: Comparing Buybacks to Investment
5.Stocks with significant buybacks between 2008-2015

© 2017 Robert L. Colby

The Net Profit Test: Comparing Buybacks to Investment

The Net Profit Test asks the question: what rate of return is required on investing the buyback funds to grow the Net Profit at the same rate as the Earnings per Share (EPS)grew due to the buyback.  If it can be shown that a low rate of return would equalize the growth between Net Profit and EPS, then the probability is high that the company would earn more money by investing.

The return that a shareholder receives when a company buys back its stock occurs at the time of purchase and only then.  It is because the Net Profit is being divided by a fewer number of shares (i.e. decimating the denominator).  This is contrasted to investing the same funds (i.e. enhancing the numerator).
In this example, the company is assumed to have bought back 10% of its shares at 10x earnings. With 10% fewer shares, the EPS is increased by 11% at the outset.
The alternative use of the buyback funds is assumed to be an investment that earns 3% in the first year, 8% the second and 10% thereafter.  As shown in the graph, the annualized returns crossover occurs in the second year and from that point on the investment is the better asset allocation decision.
buybacks-vs-investment

Surprisingly, the return generated by buybacks is independent of the price paid for the shares. Instead, the cost of the decision is measured by what the funds could otherwise have achieved if invested. In the above example, if the buyback was done at $7.20 a share, the Net Profit under the two scenarios would be equal after 8 years. However, with the buyback at $10.00, the investment would have generated 40% more in Net Profit.

(As a corollary, the higher the investment return, the lower the buyback price that can be justified.)

Our analysis of 25 companies with aggressive buyback programs from 2008 to 2015 shows an average P/E of 15x earnings.  It is also evident that most companies spend more on buybacks when their P/E’s are at the upper end of their range suggesting a higher dollar weighted P/E.

My conclusion is that few buybacks in recent years come even close to meeting the Net Profit Test. Given that S&P 500 companies alone have bought back over $2 trillion of their stock since 2009, you have to be in awe by the scope of this misallocation of corporate assets and its consequences for the economy.

© 2016 Robert L. Colby