Just yesterday, Wells Fargo (WFC 2.28%) announced it was boosting its share buyback program -- an act that typically signals financial health and a management team that feels the best use of its profits is to return value to shareholders. The stock didn't react positively though, as it ticked down almost 2% -- nearly in line with the Dow's decline. Warren Buffett and Charlie Munger often say a buyback program is great -- at the right price.
Is the country's biggest mortgage holder doing the right thing taking shares off the table, or is it coming at too high a price?
The rundown
Here at the Fool, we love to talk about Wells Fargo. The bank rose to the forefront of many discussions after it emerged from the financial crisis as one of the strongest banking institutions in the country. Today, it remains a sure bet among investors with its unrivaled mortgage portfolio that will no doubt benefit from the ever-improving housing market. The banks adept management team is known for its conservative practices in what can be a risky business.
Over the past year, the market has rewarded shareholders with a return of more than 27%, not to mention dividend income. That should come as no surprise, though, as the company has experienced 15 straight quarters of healthy profit and has the priceless confidence of über-investor Warren Buffett, whose Berkshire Hathaway (NYSE: BRK-A)(NYSE: BRK-B) is the largest shareholder of the bank's stock.
In a move that seemingly surprised shareholders and analysts alike, the company announced on Tuesday that it would be increasing its share buyback program by a whopping 200 million shares -- or nearly $7 billion based on the current stock price. The company has 5.3 billion shares outstanding, so this represents close to 4% of company's common equity.
As mentioned earlier, a move like this would typically make investors and analysts happy. Clearly, the company is in a healthy enough state to return some of that achieved value to shareholders. This move, in addition to the $0.22 per share dividend payment -- held steady from last quarter -- is about as clear a sign as any that all of the company's practices up to this point have paid off.
So, why did the stock drop? Could it have just been a factor of the major market sell-off, or do investors think the company could use the capital in a better way?
The cost
Seven billion dollars is no chump change, regardless of the size of the company. For Wells Fargo, they have already bought back $2.6 billion worth of shares during the first nine months of the year. Up until now, this has distinguished the bank from its peers, such as Citigroup (C 4.47%) and Bank of America (BAC 2.63%), who have both stayed away from increasing buyback programs until conditions improve. The largest bank by assets, JPMorgan Chase (JPM 3.02%), currently has no buyback program action, but hopes to resume one early next year. So is this really the best use of capital?
From a value perspective, a company should only repurchase shares or pay a dividend when there isn't a growth alternative available that would be a more profitable use of capital. Furthermore, share repurchases should only be done so at the right price. If a company buys back overvalued stock, it is the running the same risk that the average investor does in buying an expensive stock -- substantial downside risk and loss of capital.
Wells Fargo currently trades at about 9.5 times forward earnings. It's more expensive than JPMorgan at 7.9, and Citigroup at 8.3, but less than Bank of America's 9.9 forward P/E. Price to earnings, though, isn't always the most effective metric for valuation -- price to book is better. Using P/B, Wells Fargo is easily the most expensive, and the only stock trading at a premium to its book value. Even this warrants further explanation, as Wells Fargo arguably has the strongest asset base of any of the others and warrants that premium. So we are still left wondering -- is the buyback the best use of capital?
For the sake of closure, I'm confident that this is a productive move for the bank. Rather than increase its risk exposure or invest in other businesses, the management team is wise in returning value. It's the same philosophy behind many value fund managers -- when there is little or no reason to further invest capital, the most responsible decision is to return the capital to investors.
Wells Fargo shareholders have seen their stock appreciate almost 30% this year. If they were wise enough to buy in after the financial crisis, they've pocketed even stronger returns. Perhaps now is as good a time as any for Wells Fargo, with its industry-leading position, to give back to those who put their faith and funds in the company. From here, the company remains in a strong position, with its focus on increasing mortgage fees in the attractive housing market, and it's found a home for some of its idle cash.
