A main role of a listed company Board is capital deployment and allocation:-

 

It must tackle operating performance, it must fund organic growth/working capital/capex, and must also take investment decisions, on acquisitions & disposals.

 

And if it succeeds and matures, then the company's financing decisions move to distributions to shareholders via:-

–Ordinary dividends

–Special dividends

–Share repurchases/buybacks

 

Generally, buybacks seem popular among commentators, as shown  

 

Financial Times 17 Feb 2011

 

“Share buyback a welcome surprise”   ...  “the main highlight was the announcement of a £150m share buyback programme. At c6% of market cap, this should be 3 –5% earnings accretive.” US Broker’s research commentary on a listed company announcement

 

The trend of late has certainly been for buybacks to exceed dividends as a mechanism for capital returns (with a small hiccup in the wake of the global financial crisis):-

 

The reasons buybacks are almost invariably viewed as good include

 

– the EPS boost  (A dividend reduces eps (since the money which would otherwise earn a return on capital leaves the balance sheet, and the eps divisor stays constant, whereas a buyback increases the eps (by dropping the divisor)).

 

–it provides a "floor" under the share price which "must benefit shareholders"

 

– it is a sign of management confidence

 

 

But there is scarce a  mention of price or returns

 

It certainly looks plausible – if a company in SA can borrow at 9% (taxed cost of 6.3%), it means it is “right” to do a buyback if the earnings yield exceeds 6.3% (ie PE ratio is below 15.9X). But it can in fact harm shareholders’ returns!

 

As an example Pepsico bought back shares in 2008, and reported a higher ROE of 34.83% up from the 2007 figure of 34.53%. So shareholders should have been happy, right? But a more conservative interpretation I suggest here would have the company rather keeping the bought back shares in its calculations:-

 

$m

2008                                                                       as Published       Suggested

Shareholder‘s equity                                      12,203                   12,203

Add back repurchased shares                                                       4,720

New 2008 shareholders equity                 12,203                   16,923

2007 shareholders equity                             17,325                   17,325

Average equity                                                 14,764                   17,124

Profit                                                                      5,658                     5,142

Plus: profit attributable to shares repurchased                        220

New profit figure                                                                               5,362

ROE                                                                        34.83%                 31.31%

Share count                                                        1602m                   1670m

EPS                                                                         $3.21                     $3.21

 

So as you can see the EPS result is the same, but the decline in ROE is masked by the buyback as reported! 

 

So the widely stated view that “the way in which cash is returned to the shareholders is irrelevant” (FT Lex column 8 Jan 2010) is wrong –Buying back shares when they are not cheap destroys value for remaining shareholders

 

Why then has it become so popular? Look at this table showing a static company which makes a billion rand each year, and which over a decade elects to buy back 10% of its shares each year.

 

 

What has the buyback achieved? EPS growth of 11% per year, compounded, which has thus given the market the option of getting a rising shareprice out of a flat market cap performance. But what else - it has catapulted the value of the directors' option pool, which had "zero" value at issue, up to  9.3% of the company! So the buyback initiative has a different effect on the parties! In essence, the company sold shares at 100 to the options pool, then is buying them back at well over R200 - following a "sell low & buy high " strategy to transfer money from its shareholders to its option holders!

 

Still happy with buybacks?

 

Stuart