Why Share Repurchases Aren't Always Good for Investors

Investors count on earnings per share, or EPS, to measure earnings, not stock repurchases. Meanwhile, some companies are going into debt in order to continue their stock buyback programs. M.H. Franco Wong, Assistant Professor at the University of Chicago Graduate School of Business, said, "Repurchasing your own stock for this purpose is like taking money from your left pocket and moving it to your right pocket." When companies borrow money to buy back their shares, it's almost a crime against shareholders.

Do share buybacks create any real value?
There are two ways that companies report earnings: basic EPS and diluted EPS. Basic earnings per share is calculated by dividing earnings by the average number of common shares outstanding. Diluted earnings per share includes warrants, convertible debt, and employee stock options. 

Sometimes the share price of a stock goes up after a buyback announcement. It's believed that investors reward companies that buy back shares for not investing in other frivolous projects or acquisitions, and for sending the signal to the market that the company thinks the stock is undervalued, even if it's currently trading near its highs.

So, while share repurchases don't provide any real intrinsic value, they are used by many investors as a way to gain insight into what management "really thinks" about the value of the company. The changes in EPS and P/E are mechanical, and not linked to fundamental value creation, but these increases may provide the confidence that weary investors need to purchase additional stock. Share repurchases may also result in the company hitting the EPS target that management needs to meet their own compensation goals.

Share buybacks in the discount-retail industry
Let's look at some real examples of this in the discount-retail sector. Discount-retail margins are very thin due to growing competition. In general, it's been a hard year for the industry. These companies are under pressure to meet EPS targets. Not only are companies buying back their stock near highs, but some companies are issuing notes and using other forms of debt to raise cash for this purpose.

  • Wal-Mart's  (NYSE: WMT  ) Board of Directors authorized a $15 billion share repurchase program on June 6, 2013. The program replaces the previous program, which had less than a billion in authorization remaining. Wal-Mart retires all of the shares it repurchases and returns them to unissued status. On Dec. 31 Wal-Mart stock closed at $76.75 and the average price paid for stock through the buyback program was $74.54, up from $65.69 in 2012.
  • Family Dollar (NYSE: FDO  )  purchased 1.2 million of its shares in the first three quarters of 2013, which compares to 3.2 million shares in 2012. In January of 2013 Family Dollar announced that it had been authorized to purchase an additional 300 million shares of common stock.
  • The Board of Directors at Target (NYSE: TGT  ) approved a $5 billion repurchase plan in January 2012. Target bought 35.8 million shares for a total investment of $2,169 million at an average price of $60.54. The stock was trading at $64.79 on Oct. 31. Due to Target's poor earnings performance and its desire to not borrow money in order to buy its stock back, the company decided to halt its repurchase program, which is exactly what it should do.
  • Dollar Tree Stores (NASDAQ: DLTR  ) is going into debt in order to help pay for its stock repurchases. In September, Dollar Tree's Board of Directors authorized the repurchase of $2 billion shares. As of Nov. 2, 2013, the company had $1 billion remaining. Dollar Tree actually received authorization from its unsecured creditor to issue notes raising $750 million at ~4% interest to a group of accredited investors.
  • Tuesday Morning has a $5 million buyback program. For the three quarters ended Sept. 30, 2013 only a handful of shares had been repurchased under the agreement.

The Foolish bottom line
Share buybacks are supposed to be like dividends, or at least that's how they are presented to investors. Both practices are supposed to give money back to investors, but dividends don't increase EPS. Stock repurchases, on the other hand, can be used by managers as a way to ensure that EPS targets are met. It's not hard to find an executive who will acknowledge the connection between stock buybacks and EPS management.

The larger issue here is one of fiduciary responsibility. One study found that managers increase their "firm's stock repurchases when earnings fall short of the level required to maintain the past growth rate of diluted EPS." The question is whether or not the intrinsic value of the company will catch up to the value created through stock repurchases. At some point the stock may self-correct, and investors may be left holding the bag.

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