The Hindu Business Line : The value of share buybacks

In most cases, buybacks create value because they help improve tax efficiency and prevent managers from investing in the wrong assets or pursuing unwise acquisitions.

A DISTINCTLY thought-provoking argument has been put forward by Mr Richard Dobbs, a director in McKinsey's London office, and Mr Werner Rehm, a consultant in the New York office, that companies should not confuse the value created by returning cash to shareholders with the value created by actual operational improvements. After all, they have point out, the market does not.

In an article, `The Value of Share Buybacks' (The McKinsey Quarterly, 2005 Number 3), Mr Dobbs and Mr Rehm have conceded that markets, in general, applaud buybacks, making them "an alluring substitute if improvements in operational performance are elusive."

"... Yet, while the increases in earnings per share that many buybacks deliver help managers hit EPS-based compensation targets, boosting EPS in this way does not signify an increase in underlying performance or value. Moreover, a company's fixation on buybacks might come at the cost of investments in its long-term health."

Having made this point, they go on to add that buybacks are not entirely without value. "It is crucial, however, for managers and directors to understand their real effects when deciding to return cash to shareholders or to pursue other investment options. A buyback's impact on share price comes from changes in a company's capital structure and, more critically, from the signals a buyback sends. Investors are generally relieved to learn that companies do not intend to do something `wasteful' such as make an unwise acquisition or a poor capital expenditure with the excess cash."

And then again, the EPS may be up but the intrinsic value remains flat. According to the authors, many market participants and executives believe that since a repurchase reduces the number of outstanding shares, thus increasing the EPS, it also raises a company's share price. "As one respected Wall Street analyst commented in a recent report, `Share buybacks...improve EPS, return on equity, return on capital employed, economic profit, and fundamental intrinsic value.' At first glance, this argument seems to make sense: the same earnings divided by fewer shares results in a higher EPS and so a higher share price. But this belief is wrong... "

According to Mr Dobbs and Mr Rehm, the company's value does increase as a result of share buybacks — albeit by a small amount — when corporate taxes are part of the equation, because its cost of capital falls from having less cash or greater debt.

"The cost of capital is lower when a company uses some debt for financing, because interest payments are tax deductible while dividends are not. Holding excess cash raises the cost of capital: since interest income is taxable, a company that maintains large cash reserves puts investors at a disadvantage. In general, having too much cash on hand penalises a company by increasing its cost of financing."

They point out that the share price increase from a buyback, in theory, results purely from the tax benefits of a company's new capital structure rather than from any underlying operational improvement. The impact of this tax effect on share prices can be estimated — but historical and recent buyback announcements typically result in a much bigger rise in share price than this analysis indicates. "Research from both academics and practitioners consistently finds that companies initiating small repurchase programmes see an average increase in their share price of two to three per cent on the day of the announcement. Those that undertake larger buybacks, involving around 15 per cent or more of the shares, see prices increase by some 16 per cent, on average."

"One well-known positive signal in a buyback is that management seems to believe that the stock is undervalued. Executives can enhance this effect by personally purchasing significant numbers of shares, since market participants see them as de facto insiders with privileged information about future earnings and growth prospects."

A second positive signal, is management's confidence that the company does not need the cash to cover future commitments such as interest payments and capital expenditure. "But there is a third, negative, signal with a buyback: That the management team sees few investment opportunities ahead, suggesting to investors that they could do better by putting their money elsewhere. Some managers are reluctant to launch buyback programmes for this reason, but the capital market's mostly positive reaction to such announcements indicates that this signal is not an issue in most cases."

Therefore, Mr Dobbs and Mr Rehm conclude, the overall positive response to a buyback may well result from investors being relieved that managers are not going to spend a company's cash on "inadvisable mergers and acquisitions or on projects with a negative net present value." In many cases, a company seems to be undervalued just before it announces a buyback, reflecting an uncertainty among investors about what management will do with the excess funds. In many industries, management teams have historically allocated cash reserves poorly. The oil industry since 1964 is one example. A huge price umbrella extended by the Organisation of Petroleum Exporting Countries (OPEC) provided oil companies with relatively high margins.

"Nevertheless, for almost three decades the spread between ROIC and cost of capital for the industry as a whole was negative. Convinced that on a sustained basis the petroleum industry could not deliver a balanced source of income, many companies committed their excess cash to what turned out to be value-destroying acquisitions or other diversification strategies.

For example, in the 1970s, Mobil bought retailer Montgomery Ward; Atlantic Richfield purchased Anaconda, a metal and mining company; and Exxon bought a majority stake in Vydec, a company specialising in office automation. All of these cash (or mostly cash) acquisitions resulted in significant losses."

Mr Dobbs and Mr Rehm warn that, with cash levels at an all-time high and mergers on the rise, managers risk repeating past behaviours. "But by allowing management compensation to be linked to the EPS, boards run the risk of promoting the short-term effects of buybacks instead of managing the long-term health of the company."

"Similarly, value-minded executives in industries where good investment opportunities are still available must resist the pressure to buy back shares in order to reach EPS targets." Finally, they argue that, in most cases, buybacks create value because they help improve tax efficiency and prevent managers from investing in the wrong assets or pursuing unwise acquisitions. "Only when boards and executives understand the difference between fundamental value creation through improved performance and the purely mechanical effects of a buyback programme on EPS will they put share repurchases to work creating value."

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