Increasingly companies are using stock buybacks to squeeze their earnings per share higher, an important valuation metric for investors. For the three months ended March 2014, they stood at 159.3 billion USD, the largest amount since September 20071. Have equity market returns been inflated by this bit of financial legerdemain?
Residents of the United States, please read this important information before proceeding
During the recovery period since 2009, we have seen news of “financial engineering”, in which many successful American enterprises have used stock buybacks to manage their earnings per share. For the three months ended March 2014, buybacks stood at 159.3 billion USD, the largest amount since September 2007. (Figure 1) There has been debate in the public domain over the impact stock buybacks have had on equity market returns since the financial crisis. Here we examine the facts.
A buyback occurs when a business purchases its own shares – in the open market or via a tender offer – and then either holds them for future re-issue or cancels the repurchased shares altogether. Here are a few of the key reasons behind repurchases:
1. Add debt to its capital structure: By repurchasing shares, a company decreases its equity as a percentage of total capital, effectively increasing its leverage. Doing so may help a company optimise its capital structure: investors require less compensation for debt holdings than for equity holdings, since debts have a higher repayment priority. This is generally viewed as a buyback that enhances shareholder value.
2. Decrease agency costs: Managers of the entity act as agents for investors, and there is always the risk that they will use capital unwisely. To be seen as efficient allocators of capital and committed to the interests of investors, company managements often return excess funds to investors through buybacks. This is generally viewed as a buyback that enhances shareholder value.
3. Return excess funds: Mature businesses often find themselves in a position where they lack profitable opportunities to grow. In such a circumstance, a company’s management may determine that the most efficient use of capital is to return excess funds to investors. This is generally viewed as a buyback that enhances shareholder value.
4. Signal the market: If company management believes the company’s stock price is not correctly reflecting fundamentals, it can lead investors to reassess the value by repurchasing shares. Putting the company’s capital to work this way may carry more weight than a management discussion revising guidance upward. This is generally viewed as a buyback that enhances shareholder value.
5. Increase earnings per share: A share buyback reduces the total number of shares outstanding. Mathematically, this increases the earnings per share (EPS), as the total value of earnings is divided by a smaller number of shares. Since managers’ long-term incentive plans are usually directly related to EPS, senior managers might engage in a share buyback simply to boost EPS, when capital might be better directed to profitable growth opportunities. This is not generally viewed as a buyback that enhances shareholder value.
6. Management share option programs: Management share option programs are based on the belief that the share price should increase. An undue focus here could cause managements to favour buybacks to the exclusion of dividends. Further, a buyback that accompanies the exercise of management options simply offsets the dilutive effect of share options. This is not generally viewed as a buyback that enhances shareholder value.
Investors may prefer their funds to be returned via buybacks if the capital gains tax is lower than the dividend income tax euro
Repurchases compared to dividends
Buybacks are very similar to cash dividends, since they both represent a return of capital to investors. They have a similar effect on company’s financials, since they both:3
- Reduce assets by the amount of the dividend or repurchase
- Reduce equity by the amount of the dividend or repurchase
- Provide investors with the same cash flow before tax
However, there are two fundamental reasons why repurchases may be preferred. First, if the capital gains tax is lower than the dividend income tax, the after-tax cash flow from buybacks becomes higher than that from dividends. Second, buybacks offer more flexibility. Managers frequently are committed to maintaining dividend payments, since a failure to do so usually is followed by a very negative reaction by the investor community. However, eliminating a buyback program is unlikely to result in a similar investor reaction. This gives the company an option to cut the program if it needs to use funds elsewhere. In fact, buybacks tend to outnumber dividend payments most of the time in the US market. (Figure 2)
Repurchases: a reason for concern?
As of this writing, the cumulative total return from the S&P 500 Index since its March 2009 low is 228%.4 There are many who claim that this return has been driven by an illusion of earnings per share growth driven by the “financial engineering” of share buybacks. To test this view, we evaluated the cumulative growth in the operating earnings of the S&P 500 from 2008 through June 2014 and compared that to the per share earnings growth over the same period. (Figure 3) Operating earnings grew 131% over the period, and EPS grew about 126%, roughly in line with actual earnings growth. No illusion of growth there.
A deeper a look makes it clear that the rise in earnings per share has been due to margin expansion, not buybacks. (Figure 4) Margins expanded largely due to several factors. First, capital investment fell, and Research and Development expenses (R&D) were cut back. (Figure 5) While this can be an important category of expense for future growth, conservative cost management on the part of company managements was likely a prudent response to the extreme uncertainty of the post-crisis environment. The second factor that aided margins was the below-average amount and cost of labour used to generate the earnings post-crisis. In addition, profits were aided by revenue growth and write backs.
The value of a buyback depends on whether it has been an efficient use of capital. In short, not all buybacks have the same purpose, and sometimes buybacks can be an effective and smart way of returning capital to shareholders.
Repurchases do not seem to be an explanatory variable for rising equity prices. Rather, equity price rises seem to have been driven by earnings growth, which has been aided by expansion in company margins.