Synopsis: Stock buybacks increase corporate leverage. Investors err if they apply the old P/E ratio to the new, now higher EPS, which is solely due to the reduction of outstanding shares. Because leverage has increased, the P/E ratio should fall, as the company is now riskier.
Theoretically, via the academic discipline of corporate finance, and used by most Wall Street analysts, management should prioritize its use of cash as follows:
1. To balance its debt/equity ratio. If the company has too much debt, the cash should be used to reduce the debt and strengthen the debt/equity ratio;
2. Fund projects that will produce organic growth;
3. In the absence of organic projects, expand business by acquisition;
4. If none of the above are available, increase the dividend, as long as there is a reasonable expectation that the new dividend level is sustainable. If not sustainable, management can declare a special one-time dividend payment;
5. As an alternative to a special dividend, management can distribute the cash via share repurchases.
From a theoretical corporate finance viewpoint, then, share buybacks should only occur when companies run out of ways to grow profits. In the chain of spending, share buybacks are at the bottom. Yet, in today’s world, their usage appears to be near the top.
Determinants of Value
Top and bottom line growth are important determinants of a corporation’s share price. When earnings announcements are made, the first comparisons done are whether or not the company “beat” analyst top and bottom line projections because it is the analyst projections that were “priced-in.” Shares then adjust to the reported reality.
Today’s reality is that potential economic growth in the world’s major industrial economies is about half of what it was in the 1980s and 1990s and perhaps two-thirds of what it was pre-recession. That growth slowdown has two major components, demographics and attitudinal changes. Theoretically, then, slower economic growth should produce a much slower overall growth rate in equities, at least in the long-run, because the economic pie is not growing as fast. And that should show up in a slowdown in the growth of the major equity indexes.
Buybacks – The New Magic Beans
Share buybacks, however, appear to have temporarily stayed this reality – like magic. Companies have jumped on the bandwagon. It appears that, with just a phone call to the company’s investment banker, instructing them to buy the company’s stock on the open market, the stock price magically rises. This phenomenon occurs because analysts and the public have continued to assign the pre-buyback Price/Earnings (P/E) ratio to the company’s stock and the earnings per share (EPS) has just risen! The value of the stock increased just by making a phone call to the investment banker and providing the cash for the share repurchase. Wow! Everybody wins! Are buybacks the “New Magic Beans?”
Oops – Reality!
Oops! Wait a minute. The company spent cash; it came out of company assets. What was the double-entry bookkeeping offset? Oh – that was a reduction in retained earnings, the capital account. On the balance sheet, the equity portion has fallen, but the company’s liabilities have not. Therefore, the company is more leveraged than before, and therefore, riskier. Its Price/Book Value (P/BV) has risen. And, theoretically, its P/E ratio should fall, not stay the same. Investors today, err, when they assign the same P/E ratio post-buyback, as the company had pre-buyback.
The buyback phenomenon is well documented and has been occurring throughout the nine-year equity bull-run. The lead article of the Friday, May 11th edition of the Wall Street Journal
Headlined “Buybacks Surge, Steadying Market,” (Eisen and Otani) indicating that investors today continue to assign the pre-buyback P/E ratio to the post-buyback shares. The article indicated that companies reporting Q1 earnings through May 10th (85% of S&P 500 companies) had repurchased $158 billion of their own stock in Q1, on pace for a record quarterly buyback amount. The article goes on…
Of the 20 S&P 500 companies that spent the most on buybacks over the first quarter, nearly three-quarters have outperformed the index so far this year. The group has risen on average 5.2% in 2018, compared with the S&P 500’s 1.9% gain…
The article suggests that buybacks have been supporting the index levels:
The S&P 500 is up only modestly for the year. Yet many analysts believe major indexes would have suffered losses without buybacks.
Buffett’s View of Buybacks
In his 1999 letter to Berkshire Hathaway shareholders, reiterated 12 years later in his 2011 communication, Warren Buffett discussed corporate stock buybacks:
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.
Buffett has set his “intrinsic value” target at a P/BV of 1.2x. Whitney Tilson of T2 Partners LLC, following Buffett’s advice, uses the following rule of thumb: if the stock is trading within 20% of fair value, then the company should use dividends; if it’s trading at greater than a 20% discount, buybacks. If it’s trading at a big premium to fair value, then the company should issue stock, via compensation to employees, a secondary offering, and/or as an acquisition currency.
But that isn’t what is currently happening as is demonstrated by Q1’s record breaking buybacks. Buybacks are occurring when prices are at or near cycle highs, not near lows as required by Mr. Buffett’s sage advice.
The Apple Buybacks
In the first week of May, Apple, in its earnings release, announced a $100 billion stock buyback, and also revealed that in Q1, it bought back $22.8 billion of its own stock, more than any other S&P 500 company. On May 10th, Apple’s total market cap was $926 billion. The new $100 billion announced buyback represents 10.8% of the current value of its outstanding shares. The day after the announcement, the stock surged 4.4% and was up 13% for the full week. The stock closed at its all-time high of $190+ on May 10th .
This is the same stock that sold at $161+ on April 27th, just two weeks earlier, because the analysts were worried about the company’s ability to grow and found growth issues in Apple’s major supply chain partners. Apple’s reported revenue was $61.1 billion, just a hair higher than the expected $61.0 billion penciled in by the street. The $2.75 EPS did beat Wall Street’s expectations of $2.69. But wait! If we take into account the $22.8 billion of Q1 buybacks, about 2.7% of capitalization, then the street’s $2.69 EPS, when adjusted, becomes $2.76. The reality is that Apple “met” expectations; they did not “beat.” Perhaps the initial 4.4% spike up was a relief rally. But the next 9% can only be attributed to one thing, the announced buyback.
Potential Impact on Leverage
So, let’s look at Apple’s leverage. At the end of Q1/17, Apple had $134.1 billion of balance sheet equity (book value) – a per share book value (5.206 billion shares outstanding) of $25.76. With a 3/31/17 closing share price of $143.66, its P/BV was 5.58x. As of 3/29/18, Apple’s book value was $126.9 billion – a per share book value (4.943 shares outstanding) of $25.67. Apple’s closing share price was $167.78. So, its P/BV rose to 6.53x. Apple generates about $55 billion of cash each year. So, $100 billion stock buyback would reduce its equity by about $45 billion if done over the next year. Using $190/share as the buyback price, Apple would repurchase 526 million shares. Doing all the math, it is very possible that Apple’s P/BV could rise toward 10x from 6.5x. All of this is hypothetical and depends on when (and if) Apple repurchases, how much it repurchases, and at what price. The exercise, however, does show that significant repurchases impact the company’s leverage ratios.
The Magic Beans Raise Market Capitalization
While the immediate impact of a buyback is an increase in a company’s EPS, that buyback also increases the company’s leverage, and therefore, its risk. In reality, the company’s business has not grown, so why should its total market cap rise? A good argument can be made that, given higher leverage, total market cap should fall, especially if the repurchases are significantly above “intrinsic value.” In addition, it is a reality that stock prices of more highly leveraged (riskier) companies always fall harder, faster and farther than similar less leveraged companies when they disappoint Wall Street. And, such disappointment is usually associated with slowing or disappearing growth.
The Global Corporate Debt Binge
It is a fact that return on capital rises with share buybacks, but so does risk, as capital bases erode and debt/equity ratios rise. Given the buyback craze, it doesn’t appear to be a coincidence that corporate leverage has increased and credit quality has decreased. Within the investment-grade universe, 48% of corporate bonds are now rated BBB, a record level (pre-recession, this number was 30%, and in the 1990s, it was 25%). The net leverage ratio for these BBBs is 2.9x, up from 1.7x in 2000. Globally, median corporate credit ratings have fallen to BBB-. Pre-recession, the median was BBB. It was BBB+ in the 1990s and A in the early 1980s. This global corporate debt binge appears to go hand in hand with the buyback craze.
• Indexes are being pushed up by record stock buybacks. At first glance, using the pre-buyback P/E ratio would appear to justify this. But, unless the buyback is at a price below its book value (or its intrinsic value (about a P/BV of 1.2x) according to Buffett), the company is now more leveraged and is riskier, and the risk adjusted P/E ratio should be lower than the pre-buyback ratio. Investors err if they don’t adjust the valuation metrics.
• Buybacks generally make corporate balance sheets weaker, and data show that, on net, today’s median corporation is less credit worthy than those of the recent past.
• Markets are displaying increased volatility. Buybacks appear to be a significant contributing factor.
• There is no doubt that buybacks will continue, as investors have taken the bait that they are better off because the EPS has risen. Because those companies are more leveraged and therefore riskier, when the correction comes, the fall in those share prices will be quicker and nastier than anyone currently expects. This lesson has yet to be learned. It certainly isn’t priced into today’s market.
i A special dividend is a one-time action that is irrevocable. That is, the company pays out the entirety of the cash. The authorization by the board for a share buyback is not irrevocable. It allows management to time the purchase or not do it at all, at management’s discretion. In addition, there are tax benefits to share buybacks. Dividends are taxed twice, once at the corporate level as corporate income, and then as ordinary income to the shareholder. Assuming share buybacks increase the value of each share, then the tax is at the discretion of the shareholder which is paid only after the shareholder sells his/her shares. If held for over a year, the shares are taxed at the lower, long-term capital gain tax rate.
ii As an aside, some companies use share buybacks as a means to transfer wealth to their management via the use of options. By using cash to buy their own shares, they artificially increase the EPS which may be part of an executive’s incentive plan. The shares bought back in the open market match the options exercised by management, so that, on net, shares outstanding do not change. The regular shareholders do not “see” any dilution, as the number of outstanding shares has remained the same. But, in reality, corporate cash has been distributed to management instead of going to the regular shareholders.
iii We also learned in early May that in Q1, Buffett’s Berkshire Hathaway bought 75 million shares of Apple bringing the firm’s total to 240.3 million shares. At $190/share, Buffett owns more than $45 billion worth of the company’s $926 billion capitalization, or 4.9% of the company. During Berkshire’s annual meeting, Buffett suggested that Berkshire would be looking to increase its stake in Apple. What could he really say about Apple’s $100 billion buyback? It will clearly enhance his percentage ownership. But, at today’s record high price and P/BV ratio, it is way above Buffett’s “intrinsic value” concept! Has he, Buffett, bought into the ”Magic Beans” concept?
Robert Barone, Ph.D.
Robert Barone, Ph.D. is a Georgetown educated economist. He is a financial advisor at Fieldstone Financial. www.FieldstoneFinancial.com .
He is nationally known for his writings and Robert’s storied career includes his having served as a Professor of Finance, a community bank CEO and a Director and Chairman of the Federal Home Loan Bank of San Francisco. Robert is currently a Director of CSAA Insurance Company (a AAA company) where he chairs the Finance and Investment Committee. Robert leads the investment governance program at Fieldstone Financial, is the head of Fieldstone Research www.FieldstoneResearch.com, and is co-portfolio manager of the Fieldstone Financial Unconstrained Medium-Term Fixed Income ETF (FFIU).
Statistics and other information have been compiled from various sources. The facts and information are believed to be accurate and credible, but there is no guarantee as to the complete accuracy of this information