RSS feedIn the post on the underlying value in stocks, we discussed that stocks derive their inherent worth from the potential for the return of company earnings to the shareholder. When management does decide to return cash to shareholders they can do so in two ways - take retained earnings and buy shares back from shareholder who are willing to sell their shares or simply distribute cash payments out to share holders. These two methods represent share buybacks and dividends, respectively.
Share Buybacks
Share buybacks have been getting increasingly popular over the last few years. Eddie Lampert famously used them successfully to stimulate earnings per share (EPS) growth for Autozone over the last 10 years to propel the stock price upwards 400%. So, are share buybacks the best way to return value to shareholders? Well, buybacks have an inherent advantage in that the return to shareholders is not double taxed in the way that cash dividends would be. When a company makes money, the profits are taxed and, upon returning a cash dividend to investors, these returns are taxed again. In a share buyback, investors who agree to sell their stock to the buyback program will simply be taxed the capital gains tax they expected. Those who keep the stock do not need to worry about any taxation until they ultimately decide to sell their stock.
But, this does not mean that the return of cash to investors through a share buyback is always the best idea. In the case of those who decide to hold onto the stock, a share buyback is a use of company money that could have been invested elsewhere. Thus, the buyback needs to generate return by supporting the company’s share price to provide adequate return to shareholders. How would a buyback do this? The buyback reduces shares outstanding and supports EPS growth and thus makes every remaining share more valuable in an absolute sense. Further, it can be used by management to signal their belief that the company’s stock is undervalued and management’s commitment to providing return to shareholders. These signals are important in helping market participants to grant such stock a higher premium (read: P/E or other such value metric).
There is much room for error in a share buyback and it is hard to tell when a buy back is truly providing the return it ought to to those shareholders who decide to hold onto company stocks. After all, there’s much more at work in share price movements than simply the share buyback. But, there are situations when a share buyback is clearly not the optimal choice.
- A share buyback ought to be used to reduce shares outstanding and not simply to reduce the impact of dilutive options policies.
- Ensure that buybacks are not being used to manage earnings despite poor performance. That is, don’t just concentrate on per share earnings, but ensure that the company is still performing as far as overall net income and free cash flow standards.
- Buybacks ought to come during periods when share price is truly undervalued. In this way, the buyback has the best possibility of having immediate impact on share value.
- A company should not take on leverage to buy back shares. This increases risk and can put downward pressure on a company’s P/E.
Dividends
As we mentioned before, straight cash dividends are the most important aspect to the value of a stock. Even in the case of a share buyback, the logical extension of the buyback progression is that at some point, the company must buy back every share and the last shareholders will only sell for a value equal to the present value of expected future cash flows of the company. In the case of a company which only pays cash dividends, the company will cease to exist at some point in the future and thus the stocks are only worth the value of the dividends which can be accumulated in the future. The two processes ought to lead to similar values that are fundamentally based on capital returned to the shareholder.
Dividend policy is a very touchy subject. Investors expect consistent, regular dividends. Thus, unlike share buybacks which can be announced and carried out over whatever period management feels like, dividends typically must be paid regularly regardless of how a company is performing in the near term. Investors react very negatively to cuts in dividend, but increases in dividends typically result in resoundingly positive reactions. Management typically will not increase dividends unless they experience what they expect to be a permanent improvement in the company’s cash flow. Though, they will often manage to return a certain portion of retained earnings to shareholders. This is known as the payout ratio.
Dividends are constrained to the fact that should a company happen to experience unexpectedly good returns over a certain period, management may be reluctant to change their regular dividend as they do not anticipate being able to replicate such success. In these cases, companies will sometimes announce special cash dividends - essentially one time payments to return earnings to investors - or decide to do a share buyback which allows them more flexibility in the return to investors.
Now that we’ve examined these fundamental aspects of shareholder value, I will begin to introduce some very simple valuation techniques in subsequent posts based on the fundamental assumption that capital return is the ultimate source of value in stocks. I will also hope to make clear the value of the P/E ratio and show how it can be used in a more exacting manner to perform quick valuation on potential investments.
