In summarizing year-end results, company managements often boast about the cash they returned to shareholders through dividends and share repurchases. Certainly hiking the dividend by, say, 10% is something to crow about. But we fail to see why shareholders should applaud share repurchases. After all, they didn’t see any of that money. The beneficiaries of buybacks are sellers of the stock. These aren’t shareholders, they are former shareholders.
But what if stock price rose as investors slapped the same price/earnings ratio on a higher EPS figure thanks to fewer shares outstanding? Does this return cash to current shareholders? Not really.
Let’s take a step back and see who benefits when companies buy back their own stock:
- Shareholders dumping the stock.
- Management - if compensation is tied to EPS.
- Wall Street brokers who facilitate the buyback and earn fees.
Even if repurchases nudge the stock price higher in the short run, how do long-term investors benefit? After all, share repurchases don’t change the operating metrics. Cash that might have been invested in R&D or CapEx is instead spent on the company’s own shares. Repurchases can also have an adverse impact on the balance sheet. Companies may draw down cash reserves to fund buybacks or even take on more debt. By leveraging up, companies may face higher interest expenses, perhaps even raising the cost of future borrowings. The only direct benefit to shareholders in it for the long haul is that subsequent dividends will consume less cash flow given the lower share count.
But if management’s goal is a higher dividend tomorrow, why not pay it with cash available today?
Companies argue that buybacks are an ongoing benefit that will lead to a higher stock price longer term. However, there is no guarantee that shareholder “rewards” will have the intended effect. Investors may even penalize the company for manufacturing earnings by awarding it a lower P/E multiple.
So buying back shares could boost the stock price - or not. In contrast, a dividend goes straight to the wallet. The shareholder has flexibility and can then decide whether to reinvest that dividend back into the company’s stock, invest in a different stock, or blow it all on Ben and Jerry’s ice cream.
And what about the shareholders who benefit from buybacks – those who choose to sell when the company is buying? With all the complaints about investors being short-sighted today, buybacks are encouraging at least a subset of investors to place a sell order. Even if a buyback does push up the stock, why is that preferable to a dividend?
The table below shows how a stock buyback is supposed to work – with a lower share count raising EPS and driving up the stock price. Admittedly, the example is loaded with assumptions, including a stock price of $15 based on P/E of 15 and $1 worth of earnings. It assumes a 5% buyback bumps EPS to $1.05. With no change in the P/E, the stock price increases by just over 5%:
|
Hypothetical Impact of Buyback on EPS and Share Price |
||
|
Before Buyback |
After Buyback |
|
|
Net Income |
$1,000 |
$1,000 |
|
Shares |
1000 |
950 |
|
EPS |
$1.00 |
$1.052 |
|
Payout Ratio |
35% |
35% |
|
Dividend |
0.35 |
0.35 |
|
PE |
15 |
15 |
|
Price |
$15.00 |
$15.78 |
|
Price change |
5.3% |
|
But a special dividend paid to shareholders would generate about the same return as the buyback.
|
Hypothetical Return of Special Dividend |
||
|
Before Special Dividend |
After Special Dividend |
|
|
Net Income |
$1,000 |
$1,000 |
|
Shares |
1000 |
1000 |
|
EPS |
$1.00 |
$1.00 |
|
Payout Ratio |
35% |
35% |
|
Dividend |
0.35 |
0.35 |
|
Yield |
2.3% |
2.3% |
|
Buyback cost |
$750 |
|
|
Special dividend paid instead of buyback |
$750 |
|
|
Special dividend/share |
$0.75 |
|
|
Incremental yield (Special dividend/share price) |
5.0% |
|
Surely many investors would prefer the certainty of the dividend to a lottery ticket on a short term bump in the stock price.
Reasons to be skeptical of buyback magic
In a 2012 study, Fortuna Advisors LLC examined 700 of the largest U.S. non-financial companies during seven rolling five-year periods from January 2001 through December 2011. They found, on average, companies that devote more of their cash earnings to buybacks deliver lower total returns in the form of dividends and capital gains. The reason? According to Fortuna Advisors, “… the market sees through this engineered EPS growth and typically drives down the P/E multiple for companies that rely heavily on buybacks. This mitigates much of the perceived benefit of buybacks.”
That is, buybacks don’t do what they are supposed to do. At least they don’t do what they are supposed to do for long-term shareholders.
Making it up on volume
Some companies are serial offenders when it comes to buybacks. Each year repurchases are a big line item on their cash flow statement yet actual shareholders may or may not benefit. On the other hand, management will likely get a multi-year tailwind on the performance metrics that determine the bulk of their compensation.
Large buybacks can be particularly irksome when made by mature companies or those in slow decline. Take Hewlett-Packard (HPQ) which spent on average $8 billion buying its own stock in each of the last seven years. What if HPQ had instead sent that money to shareholders in the form of a dividend?
In the table below, we assume HPQ held its share count steady beginning at year-end 2005. We assume all the money spent on buybacks was paid in dividends instead. We add those assumed dividends to those actually paid and divide by the 2005 share count to get adjusted dividends per share (DPS):
What if Hewlett Packard Used Cash Flow for Dividends Rather Than Buybacks?
|
HPQ Historic Data (millions except per share) |
||||||||
|
2012 |
2011 |
2010 |
2009 |
2008 |
2007 |
2006 |
2005 |
|
|
Price at year end |
$14.25 |
$25.76 |
$42.10 |
$51.51 |
$36.29 |
$50.48 |
$41.19 |
$28.63 |
|
Actual dividends paid |
$1,015 |
$844 |
$771 |
$766 |
$796 |
$846 |
$894 |
|
|
Buybacks |
$1,619 |
$10,117 |
$11,042 |
$5,140 |
$9,620 |
$10,887 |
$7,779 |
|
|
Actual shares |
1,963 |
1,991 |
2,204 |
2,365 |
2,415 |
2,580 |
2,732 |
2,837 |
|
Actual DPS |
$0.50 |
$0.40 |
$0.32 |
$0.32 |
$0.32 |
$0.32 |
$0.32 |
|
|
Hypothetical Data Assuming No Buybacks After 2005 (millions except per share) |
||||||||
|
2012 |
2011 |
2010 |
2009 |
2008 |
2007 |
2006 |
2005 |
|
|
Hypothetical shares |
2,837 |
2,837 |
2,837 |
2,837 |
2,837 |
2,837 |
2,837 |
2,837 |
|
Adjusted DPS |
$0.93 |
$3.86 |
$4.16 |
$2.08 |
$3.67 |
$4.14 |
$3.06 |
|
While HPQ struggled over this seven-year period, the company’s cash flow could have been spent on additional research and development, more capital equipment, or on hiring more engineers. The company could have plowed money into new joint ventures or product innovation. Instead, HPQ spent billions on its own stock, a corporate finance decision that did nothing to improve margins or boost sales.
Despite the continued buybacks, HPQ’s stock lost half of its value over the period presented. Additionally, the incremental dividends per share that could have been paid are greater than the decline in the price of the stock. Obviously, how the stock would have fared with a bigger dividend is unknown, but at least shareholders would have received a higher tangible return along the way:
|
Summary of HPQ Analysis of Dividends vs. Buybacks |
|
|
Actual Stock price change over period (year end 2012 vs. year end 2005) |
($14.38) |
|
Total actual dividends (2006 thru 2012) |
$2.50 |
|
Hypothetical dividends + actual dividends (2006 thru 2012) |
$21.90 |
More reasons to be leery of buybacks
Companies regularly distribute stock options to executives as part of their compensation packages. If the stock price moves above the exercise price, executives can buy the stock at the exercise price from the company and immediately sell the stock in the market at the higher price. This ability to profit from a rising share price is sold to investors as “aligning management’s interests with those of shareholders.” But investors should remember the company issues shares when executives exercise their options. This increases the number of shares outstanding, diluting existing shareholders.
As a result, a key reason for share repurchases is to soak up dilution created by management’s option exercises. Options are certainly a legitimate form of executive compensation, but shareholders should realize that excessive stock options grants have real cash flow implications.
Additionally, companies are most likely to buy back stock when times are good – and by no coincidence, when stock prices are high. Meanwhile, such buybacks are largely discontinued in bad times, when stock prices are low and cash is tight.
According to data from Standard & Poor’s, S&P 500 companies spent four times the amount on buybacks in 2007 as they did in 2009 despite much lower prices. Thus, companies often repurchase their own shares at inflated prices which limits the advertised benefits of buybacks.
The chart below contrasts the amount spent on share repurchases versus the price of the S&P 500. Note how companies tend to “buy high” rather than “buy low.”
This buy-high behavior could be eliminated if management truly aligned their interests with shareholders – by paying out dividends rather than repurchasing stock.
Jeff Middleswart is a Senior Analyst for Ranger International. The views set forth in this essay are solely those of Mr. Middleswart, and do not necessarily represent the views of Ranger International as a firm, nor any other member of the portfolio management team. As such, views set forth in this essay may be inconsistent with Ranger International’s portfolio positions or objectives.
Data from third party sources may have been used in the preparation of this commentary and neither Mr. Middleswart nor Ranger International has independently verified, validated or audited such data. As such, neither Mr. Middleswart nor Ranger International can guarantee its accuracy. In addition, neither Mr. Middleswart nor Ranger International accepts any liability whatsoever for any loss arising from use of this essay or any information, view, opinion or estimate herein.
The views expressed herein do not constitute research, investment advice or the recommendation for the purchase or sale of any security. Past performance of the asset classes discussed in this article do not guarantee future results.
© Ranger International
