When buying a business, you are essentially becoming a silent partner in that business. Sure, you have a say in the meetings and you get the annual reports; still, you don’t have any real control over the day-to-day operations or the allocation of the company’s (your) cash.
When a company buys back stock, it is using your cash to increase your ownership by reducing the number of outstanding shares. You end up with a bigger piece of the pie. That’s a good thing, right?
Casey had posted this comment:
One topic I have not seen you address. Share buybacks and the effect on shareholder equity. Esp. the effect on your equity growth calc. When a company undertakes a significant buyback the equity in effect goes down due to accounting regs…I guess if you could give me some thoughts on addressing the buybacks that would be great.
The Buyback Effect On Equity
When a company buys back stock, it puts those shares in its treasury-stored to be later retired or resold to raise more money. Treasury stock is not entitled to receive any dividends, is not used to calculate earnings per share, and can not be voted.
In a stock buyback, the company is essentially trading its cash for stock. At the end of the transaction, our company no longer has that cash; but, we also own a larger piece of the entire company.
A Larger Piece of What?
If you own 100 of XYZ Company’s 1,000 shares, you own 10% of the company. When it buys back 100 shares (assuming you don’t sell yours), you now own 11.1% of that company-100 shares out of 900 outstanding.
But here’s the kicker-buying back shares results in less assets and lowered shareholder equity. That can be great-or horrible-for shareholders.
The Ideal Buyback
In an ideal world, your company will only buy shares back when they are selling at a discount (preferably a deep discount) to their intrinsic value. In doing so, your company would essentially be buying back $1 of its business for $0.50-greatly increasing your interest in the future value of the business.
The Almost Ideal Buyback
The other way your company can wisely reward you is by using its excess cash to repurchase shares because it does not expect much more growth. Rather than pay you a taxable dividend, it can increase your ownership and money by giving you a larger piece of the pie.
The Institutional Imperative
Unfortunately, many businesses buy back stock because they see other companies do it and think that they should. When this happens and stock is repurchased at any price, it may end up hurting your return rather than enhancing it.
How To Represent This On The Spreadsheet
When looking at a valuation spreadsheet or analyzing past shareholder equity, you are trying to find consistency in the business. The true value of the company lies in the future.
If you see shareholder equity declining, but you know that it is due to stock repurchases (rather than the accumulation of too much bad debt), don’t fret. Your business might be doing something good.
But here’s a thinking point: You want to identify growing businesses with solid moats. Why is that company buying back shares? Is management having a hard time allocating cash? Does the board see value in the current stock price? Or, are they just morons?
Most are just morons.
Filed under: How to Think About Investing
Joe,
Thanks for the great information. I have just recently stumbled upon this site and have become fascinated with your teachings regarding company valuations.
I found today’s blog on stock buy backs very interesting. I already own some Toyota stock but wonder if it was a smart buy in the $118 range. What is your take on TM and their recent stock buy back plan ? Smart move as it may relate to an undervalued stock or are they also morons ?
Thanks in advance and please keep up the blogging. I’ve become addicted to your writings.
Jeff
( REPLY )
I’m going to take a stab at this and answer my own question based on your examples and morningstar. This will be my first attempt at this.
If I look at TM’s free cash flow from 2001 to 2007, I get
2001 $ 12,887
2002 $ 12,265
2003 $ 16,978
2004 $ 20,096
2005 $ 22,148
2006 $ 22,341
2007 $ 27,749
which calculates to a 13 % growth rate
Since times are tough on the auto makers, I will give them a break and lower this rate to 10% for the next 5 years
2007 $ 27,749
2008 $ 30,523
2009 $ 33,576
2010 $ 36,933
2011 $ 40,627
2012 $ 42,658
total = $ 212,069
I expect TM to generate $ 212,069 in future cash by 2012
Using M$ Excel and a discount rate of 15% ( =NPV(15%,2012-2007,212069-0) ), I know that I will need to invest $ 160,358 today to buy this future cash.
If I add in today’s total equity of $ 99,042 , I arrive at an intrinsic value of $ 259,400 Mil or $ 259.4 Bil
Since there are 1.8 Bil shares OS, I can see that (259.4 / 1.8) = $ 144 share price
Using a margin of safety of 25%, my target price would be $ 108
It looks like I may have overpaid at $118 unless my logic is flawed. Hmm…. should I hope so or not…
And, back to my original question, could this value be higher with the TM share buy back ?
Sorry for the lengthy post
Thanks,
Jeff
( REPLY )
Ok. Looks like I missed a key point in your company valuation tutorial.
I didnt predict enough years of cash flow for TM. I think that I thought that I was closing in on a normalized rate or something. I should have used a multiplier like 20.7/23.5 to compare my approximation.
What is the significance of projecting for exactly 20 years ?
( REPLY )
SP: When a company “cancels” shares, they are removing them from the treasury and getting rid of them altogether. Those shares will no longer exist. That is a good thing for investors because $1,000 of assets on 1,000 shares means we get $1 of assets per share. $1,000 of assets on 500 shares means our interest effectively doubles to $2.
Jeff: A company has basically three values – the liquidation value, the ongoing “forever” value, and the “somewhere in-between” value. In general, when valuing a business, I don’t expect it to continue forever and I don’t expect it to break up tomorrow. As such, I try to value it as if I were going to hold it for twenty years, and then decide what to do with it.
You can value it for ten years, and then add a sales price in (a la Mohnish Pabrai) or value it forever and just put a dollar amount on cash flow and ignore the assets entirely. I have found that the 20-year valuation gives a very tight correlation between price and value over the long-term.
Hope that helps!
( REPLY )
I have held Waste management for at least 5 years now and they have been buying back shares for @ least 3 years now, but my question is this. If they buy back lets say 10 million shares in 08 and today they are showing 500 million shares outstanding at what point do they adjust the number of outstanding shares? I wouldn’t think they could do this on a day to day here.
Also is there any restrictions as to how they can buy back shares., after all whats to stop them from putting out bad news only to buy back at a lower price.
Your input would be great.
( REPLY )
Andy,
I took a look at their annual reports and I see what you mean. I think the confusion is in the language. Many companies list “issued” and “outstanding” on the balance sheet. WMI only shows “issued” and you have a touch of math to do. As it stands, the company has:
- 1,500,000,000 shares authorized (if they need to sell more to the public);
- 630,282,461 issued (meaning someone owns them);
- 96,598,567 in treasury (meaning the company owns 96 million of the 630 million issued.
If the company reported the “outstanding” on the balance sheet, you would see 533.7 (~630.3-96.6) million in fiscal year 2006 and 552.3 (~630.3-78.0) million in fiscal year 2005.
In Item 5 of the company’s 10-k (annual report), they confirm that they repurchased ~31 million shares. Above, we show a reduction of 18.6 million shares. That means the company issued (via options or otherwise) another 12.4 million.
They will adjust the amount for every quarterly and annual report.
As to the second part of your question, a company is not supposed to be able to manipulate its stock price in the way you mentioned. If a company manipulates its news to inflate or depress the price, the SEC and attorney general will have a field day taking the executives to court. That said, I’m sure that the scenario plays out to a certain degree in reality. The old balance-between-what’s-legal-and-what’s-profitable tightrope act that a small number of companies will try.
( REPLY )
Thanks Joe.
Some of my random thoughts:
I know this is not as much a spreadsheet issue as one would like. Bottom line, are the other factors (ie: owner earnings growing) trending as one would like, then make an assesment as to the effect of the buyback.
Problem with just adding back buyback to equity is then where do we place that adjustment in our spreadsheet. The cash would be higher if not for the buyback, so CROIC would be lower. I guess the way the spreadsheet is set up that is taken care of.(?)
Do you even recommend as part of the “art of valuation” to perform an addback to equity for purposes in the spreadsheet? Similar to removing a down year in a company’s past due to some irregularity?
Guess it is an “educated gut feel kind a thing”.
Thanks for taking the time to put your original post up, it is much appreciated.
( REPLY )