The basics of buybacks

You’ll have come across them in newspapers and in the pages of this publication, but are you left wondering what is meant by a ‘share buyback’? And are you baffled because Intelligent Investor sometimes heaps praise on the use of this capital management technique, but at other times pans it as destructive to shareholders’ wealth? Accusations of schizophrenia aside, there is a valid explanation. But we’ll get to that a little later, first, let’s cover the basics.

When a company has surplus cash above and beyond its medium-term requirements, a decision to return that surplus ‘capital’ to shareholders is often made. Directors can do this by increasing the regular dividend, paying a special dividend or making a capital return. All three options shrink the company’s bank balance and return money to every shareholder pro rata. But these aren’t the only options.

A buyback also returns capital to shareholders, but on a selective basis. Instead of giving money to every shareholder, the company uses its excess cash to buy back shares and then cancels them. Those shareholders who want cash can sell some or all of their shares, while those who don’t sell end up owning a slightly larger percentage of the business—and therefore have a more valuable shareholding. That’s the theory anyhow.

The harsh reality is that if a company is buying back its own shares above their underlying economic worth, or ‘intrinsic value’, then the continuing shareholders are actually getting burned—although they usually won’t realise it. To show why that’s so, let’s consider the simple example of a listed ‘cash box’, a company with no liabilities and no assets other than a big bank account. This company starts off with $100m in the bank and 100m shares outstanding, which equates to net tangible assets (NTA) of $1 per share. At the prevailing interest rate of 5%, it should achieve earnings of $5m on its cash hoard, equating to earnings per share (EPS) of 5 cents (we’re also ignoring tax). For the purposes of this example, we’ll assume that the intrinsic value of each share is equivalent to its cash backing, or NTA, of $1.

As you can see in the second column of the table above, if the company completes a buyback of its stock at exactly this intrinsic value of $1, it has no effect on the per share NTA or EPS. The shareholders who sold got a fair price, while those who held on haven’t gained or lost from the transaction. In this situation, we’re ambivalent about the buyback.

The third column shows what happens when the company buys back shares at $1.20—well above intrinsic value. In this case, remaining shareholders see the NTA of their investment fall to 95 cents and EPS fall from 5 cents to 4.75 cents. In other words, this is a buyback that is wealth-destroying for remaining shareholders. It stands to reason, really, as the pie is only so big and if the selling shareholders are getting more than their shares are really worth, then the remaining shareholders must be getting jibbed. Unfortunately, a large number of buybacks fall into this camp.

The fourth column shows our favourite type of buyback: one that’s well below intrinsic value. For whatever reason—undue pessimism, fear or boredom—there are investors happy to sell their stock back to the company at 80 cents. This causes the NTA and EPS of the remaining shares to rise. Again, it makes sense that if the company is buying its shares back at bargain prices, this will add value for those shareholders who patiently hold on.

Unfortunately, few companies are as easy to analyse as our listed cash box example. Determining intrinsic value is rarely as easy as punching a few numbers into a calculator. Most assets and earnings streams aren’t as easy to value as cash in the bank. So the decision-making process becomes more subjective; but the theory holds true nonetheless—if a stock is cheap then a buyback will benefit remaining shareholders, if a stock’s expensive then it won’t.

You could use our recommendations as a guide. If we have a negative view on a stock, it’s usually because we think it’s overpriced. In that case, a buyback would be great for those selling out, but harmful for those staying on board. Our panning of the BlueScope Steel buyback in issue 170/Mar 05 (Sell—$9.75) was a case in point. Alternatively, when we have a positive recommendation, we’d usually feel that a buyback is detrimental to sellers but great for those holding on. Our support of the buyback by Wilson Investment Company is a good example.