CarMax Inc. Is Doing a Two-Billion Buck Buyback, but Is This a Good Idea?

With the stock market at record highs, and Fed's Quantitative Easing program at an end, you might think investors would be starting to get nervous about stock valuations. But not everyone's nervous. Some seem downright ... excited!

Managers at corporations, for example, seem to think stocks are so cheap that they're willing to spend billions (and more billions) of dollars buying back their own stock. Case in point: A couple weeks ago, used car superstore CarMax (KMX 2.55%) announced plans to plow another $2 billion into repurchases of its own shares -- more than tripling its repurchase authorization to roughly $2.9 billion.

Is this a savvy financial move to buy up shares that became dramatically cheaper after Q3 earnings? Or is management simply "throwing money at the problem," spending shareholder cash to support its stock price? (And if that's the plan, it's working: CarMax stock is up 17.5% since the buyback was announced.)

Can it pay?
Um, no. Or at least CarMax isn't currently capable of fulfilling its buyback plans right away.

According to S&P Capital IQ data, while management intends to spend $2.9 billion buying back CarMax stock over the next couple years, as of today the company only has about $355 million cash on hand today. Subtract out long-term debt of $7.6 billion and CarMax is actually in the hole by about $7.3 billion.

It's also not clear whether management can buy back all these shares with cash generated by its business. Capital IQ figures show CarMax to be running free cash flow negative currently -- and to the tune of about $1.1 billion in negative free cash flow annually. Indeed, CarMax's cash flow statement shows that it has not generated positive free cash flow in any year since as far back as 2010.

Should it pay?
While CarMax's buyback announcement has already had the salutary effect of pushing up the price of CarMax stock, the real question that long-term shareholders need to ask is whether management is getting a good deal on these shares that it's buying back. To figure out the answer to that question, let's take a look at how CarMax stock's valuation stacks up against that of its peers:

Peer comparisons  courtesy of Finviz.com

From the perspective of a pure value investor -- one who agrees with master investor John Neff that you get your best values from buying companies whose P/E is no greater than the "total return" from a stock's earnings growth and dividend payouts -- CarMax stock doesn't look like a great bargain. To the contrary, with a total return ratio of 1.6, CarMax stock is arguably the most expensive stock in the used car industry today.

The upshot for investors
Now combine this fact with the fact that the quality of CarMax's earnings (upon which the stock's P/E ratio is based) seems questionable (due to the lack of free cash flow backing up the reported earnings). What are we left with?

Although CarMax's buyback program has inarguably benefited shareholders in the short term (by pushing up the price of the shares) to preearnings levels, in the long term, the company will have significant difficulty following through on its buyback plans.

In short, the cash needed to complete this buyback just isn't there. And even if it were there, CarMax stock looks too expensive to be buying in any case.