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Monday, October 19, 1998

An Investment Opinion
by Paul Larson

An Introduction to Share Buybacks

Unlike years past when paying out dividends was the rave on Wall Street, company share repurchases are en vogue today as a way to compensate shareholders with a company's excess cash. As we will look at in a moment, share repurchases enhance shareholder value in many ways.

One of the reasons companies are opting for share repurchases over dividends is that shareholders often prefer capital gains over the current income that comes form dividends. In addition, dividends are double taxed since all profits a company earns are taxed at the corporate level. If a company wishes to pay out some of its profits in the form of a dividend, the shareholders also have an income tax liability. In this type of environment, it makes sense that dividend yields of stocks are near all-time lows at the same time that share repurchase activity has been extremely brisk.

Let's now quickly take a look at why a company buying back its shares with excess cash tends to increase value for shareholders. Share repurchases by their very nature decrease the number of shares outstanding. Having fewer shares outstanding not only increases the relative percentage ownership of the remaining shareholders, but also the percentage claim on the company's profits. Said another way, buying back shares increases the earnings per share (EPS) assuming that net income is at least steady. If a company can manage to increase earnings at the same time it is retiring shares, the growth in EPS is compounded.

If a stock's price is its market-assigned price-to-earnings (P/E) ratio multiplied by the earnings per share, it only makes sense that an increase in the EPS would translate to an increased price given a steady P/E multiple. Mathematically, it looks like this:

Stock Price = EPS * P/E Ratio

Using the above equation helps to explain a stock's valuation when thinking about many other valuation topics, not just share buybacks. In any case, if you increase the right side of the equation, the left side (the stock price) will also appreciate.

Another way to look at why share buybacks tend to increase shareholder value is by thinking about the equilibrium between supply and demand for any given stock. If demand remains constant and the supply (number of shares outstanding) decreases, prices in a free market tend to rise. This is nothing more than simple economics.

Reducing excess cash can also have a dramatic affect on some important efficiency metrics that many investors look at. Still assuming that a company's net income remains constant over time, share buybacks also tend to increase both a company's Return on Assets (ROA) and Return on Equity (ROE). Let's again look at some simple math to see why this is true.

Return on Assets = Net Income / Average Assets

Since cash is certainly part of any company's assets, it again makes sense that reducing assets by spending money to buy back shares would increase the ROA, all else being constant. Substituting "Equity" for "Assets" in the above equation also shows why share buybacks tend to increase ROE with steady profits.

Yet another way to think about why having too much cash might drag down returns is to just look at what cash is yielding these days. Having great amounts of cash on the balance sheet yielding after-tax returns of 3% is going to bring down the weighted average returns on assets and equity. Of course, having a lot of cash on the balance sheet decreases risk, but its role in hampering returns should also be clear.

Share repurchases, unfortunately, are not always successful. One of the worst times a company can buy back shares is when the company's core business is taking a hit. When investors start selling a stock down because of a deterioration in the fundamental health of a company, many times executives (who more times than not own stock options) are enticed by the temporary positive effects that share buybacks may yield. But if the company's future fortunes are truly coming into question, buying back shares often just wastes valuable cash that may be needed to shore up the business down the road. In other words, share buybacks done poorly can exacerbate a bad situation.

Witness Vivus (Nasdaq: VVUS) and Rainforest Cafe (Nasdaq: RAIN). They represent recent cases of companies that have faced crumbling financials yet continued their share repurchases. The result has been company cash wasted buying back shares at significantly higher levels than where the stock is currently trading. Looking at which companies are buying back shares can often reveal good buy candidates, but the fundamental business strength should be the primary concern.

Another time investors should look on share repurchases with an inquisitive eye is when a company has a high amount of debt. In this case, buying shares back represents nothing more than an increase in a company's leverage, not really a return of excess cash. Almost by definition a leveraged company's cash is not excess. Two companies that found out the hard way that maybe paying down debt would have brought better results than buying back shares include casino operators Circus Circus (NYSE: CIR) and Trump (NYSE: DJT). Both companies have kissed some liquidity good-bye at higher stock prices while doing nothing more than increasing the net interest expense on their income statements.

Nevertheless, the list of companies that have successfully bought back shares reads like a who's who of the blue-chip universe, including companies such as Coke (NYSE: KO), Intel (Nasdaq: INTC) and Chrysler (NYSE: C). While there are always some exceptions to the rule, share buybacks tend to enhance shareholder value when done properly. Investors will serve themselves well if they know why repurchases work and can spot the difference between what is a bona fide return of capital to them and what is merely a company playing games and leveraging up.

Related Links:
Why Share Buybacks Matter