Share repurchases are becoming ever more popular among investors and management. In theory, this trend makes sense – there are major tax benefits to buying back shares as opposed to issuing dividends. In practice, however, share buybacks are often not well executed. Too often, investors focus on the profitability of a firm and spend too little time researching how those profits are used.
Before going any further, the data for this article was pulled from our internal databases and can be found here. The chart below shows the annual price of the S&P 500 and the dollar amount of share repurchases by all firms listed on major exchanges:
The amounts in the chart above are irrelevant, what is interesting however, is the positive correlation between stock prices and stock repurchases. As investors know, stock repurchases should be made when prices are below their intrinsic value. Perhaps stock prices were below their intrinsic value in 2007, but if so, then why the depressed purchases in 2009 when prices were even lower? It could be argued that the increase in repurchasing numbers is due simply to the increase in stock prices and does not represent an increase in the number of shares being purchased. That is not that case however. The chart below shows the same data indexed to the starting year and shows the percentage increase (decrease) in repurchase dollars and stock prices.
As stock prices increase, share repurchases increase at an even faster rate, and as stock price decline, the amount of share repurchases decline even faster. As an investor you have to pay attention to how earnings are put to use, and whereas a firm’s dividend policy is easy enough to judge, share repurchases are often ignored or poorly understood by investors. Two examples in particular illustrate how even a solid firm can badly manage its share repurchases.
Starbucks (SBUX) and Procter & Gamble Co. (PG) were all very profitable during the decade between 2002 and 2012. Neither of the firms ever had a return on equity below 10% during that time period.
Starbucks had total earnings of over 6.5 billion dollars and spent nearly 5 billion on share repurchases between 2002 and 2012. In 2002 the company had 777 million shares outstanding; in 2012 it had 749 million shares outstanding. Even if you credit Starbucks with the 1.5 billion earned by re-issuing shares, they still spent an average of $125 per share in repurchases. At the 2012 book value this gives a price-to-book of about 19. No one really knows what the “intrinsic” value of a share of Starbucks is, but it is probably not above 19 times its book value.
Proctor & Gamble had total earnings of over 53 billion dollars and spent nearly 37 billion on share repurchases between 2002 and 2012. The 10 years between 2002 and 2012 saw shares outstanding increase from 2,602 million to 2,748 million. Most of this increase was due to the acquisition of Gillette. Essentially what happened during these years is that management heavily diluted shareholders to make an acquisition and then used about 70 percent of the company’s profits in the following years just trying to undo that dilution. Gillette has brought increased value to Proctor & Gamble, but it is unlikely that the value added outdoes the dilution and the lost earnings spent to buying those shares back.
A simple, but effective method of judging the quality of share repurchases is to look at the average price-to-book value of the shares bought. Obviously, the lower the better. Just how low depends on what rate of return management could have gotten by reinvesting the earnings back into the company. If a firm generates a return on equity of 10% with current equity capital, but would only generate about 5% on any additional retained earnings, then it would be worthwhile for the firm to buy back its shares up to a price-to-book of 2. The logic is simple: management should deploy profits where they generate the highest return. If they can only reinvest in the company at a 5% return, but the company’s existing capital is generating a 10% return to stockholders – then they should buy shares in the company itself up to a price twice that of the book value.
Now that sounds easy to calculate but it isn’t. It is doubtful that even the most well informed management and investors know what retained earnings yield at the margin. However, such certainty is unnecessary. Going back to a previous example, it is doubtful that Starbucks’ best investing option was to buy its shares back at 19 times book value. Even if there really was an expected return of 0% on any additional retained earnings, it would have been better to simply return the profits to shareholders via dividends.
The popularity of share repurchases in recent years has allowed managements to simply buy shares back without too much scrutiny. One of the best ways to judge management’s competence and its commitment to shareholders is to look at its past record at repurchasing shares. In almost all industries, management has much more control over how to distribute profits than they have ability to generate them. As an investor, once you find a profitable company, look at the historical share repurchases – there are few better ways to gain insight into how well management will handle your profits going forward.