Shareholder yield has gained attention in recent years as a key valuation metric. The measure compares the cash flow a company is “returning to shareholders” to a stock’s market value. Shareholder yield is similar to the price-to-free cash flow ratio or enterprise value-to-EBITDA (Earnings Before Interest, Taxes, Depreciation & Amortization). Like those more traditional measures, shareholder yield attempts to show the relationship between cash generated by an investment and the cost of that investment.
But shareholder yield takes the relationship between cash flow and share price a step further, both arithmetically and philosophically. That is because the numerator includes only certain uses of cash flow – dividends, share buybacks, and debt repayment. This sum is divided by the market value to result in a “shareholder yield.” Proponents argue that these three components reflect returns to shareholders. Further, they assert that all three uses of cash are equally beneficial. Bottom line: The higher the shareholder yield the better.
We are not so sure. While shareholder yield might serve as one tool to compare similar companies, we are leery of leaning too heavily on the measure. Income-oriented investors in particular should not confuse shareholder yield with more traditional measures of income.
But shouldn’t an investor want to pay as little as possible for a stream of cash flows? And if those cash flows are destined for the shareholder’s pocket, should they not be especially prized?
Allocation, allocation, allocation
As we understand it, the quest for shareholder yield is a search for efficient allocators of capital. Yet the measure has nothing to say about the most important allocation decision a company makes – the level of capital expenditures. To even get to “free cash flow” you must first subtract capex from cash flow from operations. Capex is the critical capital allocation decision. But shareholder yield leaves it unaddressed. Nor does shareholder yield indicate the profitability of those capital investments. Are the returns acceptable? Or have past investments resulted in subsequent write-offs? Is the company underinvesting to bolster EPS (via lower depreciation expense)? Or is management intoxicated with empire building and over-spending?
Important capital allocation decisions may not even show up on the cash flow statement. Companies may scrimp on marketing expense or research and development to bolster short term results. If they are simultaneously buying back stock, the shareholder yield may look attractive, but key spending decisions may not be in the best interest of shareholders.
Shareholder yield also has nothing to say about acquisitions. While spending on acquisitions is not part of the shareholder yield calculation, it is often a company’s largest use of cash flow. Investors must ask, “Do these deals make economic sense? Or are they a tool to provide the illusion of growth with write-offs to come two or three years later?”
Advocates of shareholder yield might argue that they are interested in investing only in efficient capital allocators and that the components of shareholder yield are simply what is left after the investing in every project offering an adequate return. The excess cash flow is just that – excess.
We too prefer to invest in efficient capital allocators, but shareholder yield alone gives us no indication of management’s ability to invest efficiently.
Further, using shareholder yield as a primary stock selection criterion effectively weighs the three uses of cash flow equally. For example, advocates often are ambivalent as to whether a company pays a dividend or buys back shares. Further, a company that pays a dividend and buys back shares is awarded a higher shareholder yield than one paying only a dividend (all things equal), and is therefore deemed more attractive. We think this is a flawed assumption.
In our view, the various uses of free cash flow are not equal. We can’t speak for other investors, but we prefer dividends to buybacks. The most important reason for our bias is the most obvious in our view – returns from dividends cannot be taken away.
Consider two identical companies, each with $1 million in free cash flow. Let’s assume each has 1 million shares outstanding, allowing each to either pay a $1 dividend or buy back 5% of its own shares. Company A chooses to pay a dividend while Company B repurchases stock. An investor in Company A will pocket the $1 dividend. An investor in Company B receives no dividend, but will own a slightly larger portion of the company given the reduced share count. Assume this scenario repeats the following year.
At the end of the second year, the investor in Company A has earned a total return of $2 plus the change in the price of the stock. The total return for the investor in Company B is the change in the price of the stock alone. The ending stock price reflects the EPS at the end of Year 2 and the valuation the market places on those earnings. While EPS will be higher for Company B given the fewer shares outstanding, there is no guarantee that the company’s valuation will not contract over the holding period. That is to say, the price-earnings ratio – that snapshot of fluctuating investor sentiment – is a key determinant of investor returns from share buybacks. The dividend, meanwhile, is money in the bank.
Certainly, investors in Company B may also earn a negative return if the P-E contracts. But investors in company A have something Investors in Company B do not: They have $2.
Now it is impossible to say whether the market will eventually value Company A or Company B with a higher multiple of earnings. But given the risk of foregoing a certain $2 for an uncertain appreciation of some amount, someday, should investors really remain indifferent to buybacks and dividends?
When it comes to allocation of resources, the question is not always buybacks vs. dividends, but buybacks vs. all other options. As noted earlier, using shareholder yield as a primary investment criterion assumes that the company invests in all projects that offer an acceptable return. That assumption may be naive. Executive compensation based on EPS growth provides a strong incentive to shrink the share count now rather than wait for capital investments to generate returns down the road. We suspect that too often an EPS target is set, a buyback plan is developed, and whatever is left over will be directed toward capital investments or increasing the dividend.
Such capital allocation decisions argue against using the level of stock buybacks as an indicator of shareholder friendly behavior.
Valuation based on good intentions
Similar to the dividend yield, the shareholder yield reflects corporate actions already taken, say over the trailing 12 months. However, just as there is nothing to prevent the company from cutting its dividend, there are no guarantees that buybacks will continue. Yet, financial analysis and a review of dividend history can provide a level of comfort that payouts are well covered. And given the market’s reaction to dividend cuts, there is some pressure on management to maintain the dividend.
While financial analysis may indicate that cash flow is likely to be available for repurchases, whether or not the share count will keep shrinking is hardly predictable. For example, companies historically have purchased fewer shares in periods of stock market weakness. In fact, there is nothing like a bear market to persuade companies to halt buybacks.
Further, even if companies spend large sums on buybacks in consecutive years, issuance related to the exercise of stock options can limit the net reduction in shares outstanding.
There are also portfolio management implications to erratic trends in net repurchases. First, if the shareholder yield changes frequently, an investment strategy based on this metric could result in high turnover. This might not pose a problem high turnover is expected. Investors expecting the portfolio managers to take a longer term view, however, could be surprised by how the strategy is executed.
Conversely, companies with a high shareholder yield that do buy back their own shares year after year may not have the attributes investors seek. Slow growing companies may resort to massive share buybacks while top line growth continues to slide. Such companies may prove attractive to value investors for company specific reasons, but a high shareholder yield alone does not equate to an attractive investment in our view.
Finally, while much research has concluded that high P-E stocks tend to underperform their more reasonably valued peers, company managements are incented to ignore valuation and boost EPS with buybacks. Again, such a capital allocation decision is unlikely to be in the best interest of shareholders.
To get a glimpse of the relationship between growth and stock buybacks, we ran a Bloomberg screen on the S&P 500. We next sorted the companies based on “buyback yield.” That is, we divided trailing 12 month net repurchases by current market cap. We then downloaded 3-year average sales growth for all companies in the index. We found that the top 20 companies with the highest “buyback yield” generated only 3.1% average sales growth compared to 6.8% for the entire index. Among the companies with the 20 highest buyback yields were Motorola Solutions (MSI)1, Viacom (VIAB)2 and Juniper Networks (JNPR)3 – all companies with slow or negative growth of late.
To sum up, we agree it is important to compare a company’s market valuation to the amount of cash flow the company can generate. However, while a metric such as price-to-cash flow may indicate a company is attractively valued vs. other investment candidates, it says nothing about management’s ability to allocate its cash flow for the long term benefit of shareholders. Similarly, shareholder yield may also indicate an attractive valuation, but the measure rewards companies that repurchase significant amounts of their own shares regardless of the price of the stock, the level of dividends being paid, and the potential for further investment in marketing, R&D, or capital spending.
That is not to say that share buybacks are always a poor use of capital. We will leave it to Warren Buffett to explain when repurchases might be a good idea:
There is only one combination of facts that makes it advisable for a company to repurchase its shares: First, the company has available funds -- cash plus sensible borrowing capacity -- beyond the near-term needs of the business and, second, finds its stock selling in the market below its intrinsic value, conservatively calculated.
-- Warren Buffett, 1999 Shareholder letter
The first law of capital allocation – whether the money is slated for acquisitions or share repurchases – is that what is smart at one price is dumb at another.
-- Warren Buffett, 2011 Shareholder letter
One might well take shareholder yield at face value when considering an investment in a company run by Mr. Buffett. Otherwise, while a high shareholder yield may indicate an attractively valued investment, other boxes should be checked as well.
1 Ranger International strategies do not have a position in Motorola Solutions (MSI).
2 Ranger International strategies do not have a position in Viacom (VIAB).
3 Ranger International strategies do not have a position in Juniper Networks (JNPR).
