Forum Home Page [see Broadridge note below]

 The Shareholder ForumTM`

Fair Investor Access

See related case examples of

Dell Inc.

appraisal rights for intrinsic value realization

and

Walgreen Co.

stock buyback policies

"Fair Access" Home Page

"Fair Access" Program Reference

For graphs of specific company and related industry returns, see

Returns on Corporate Capital

For graphs of specific company voting for the past 5 years, see

Shareholder Support Rankings

 

 

 

Forum distribution:

Corporate advisors encourage stock buyback decisions based on rational projections of future share prices

 

For recent attention to investor interests in the capital allocation decisions addressed below see the Forum workshop for  Buyback Analysis and the "Stock Buyback Policy" section of the reference page for the Forum's 2014 project reviewing a buyback controversy.

 

Source: CFO.com, May 5, 2017 commentary

 


Capital Markets

 

How to Tell Good Buybacks from Bad Ones

Buyback ROI, a tool first introduced on CFO.com, can be used by executives and investors to determine when buybacks are more likely to be successful.

>> Gregory V. Milano  and Joseph Theriault, Contributors

May 5, 2017 | CFO.com | US


Almost six years ago, we introduced Buyback ROI on CFO.com in an article titled, What’s Your Return on Buybacks. Buyback ROI is defined as a company’s annualized rate of return based on the cash spent on buybacks, the money saved by “avoiding dividends” on the repurchased shares, and the change in the stock price since the buyback. Since that initial publication, Buyback ROI has been used by companies and investors to compare the return realized on buybacks to the returns earned on other uses of capital such as acquisitions and capital expenditures. It has become a useful tool in evaluating capital deployment effectiveness.

This week, Fortune published an article and ranking on this measure, utilizing information from our Buyback ROI Report 2017. At a time in which buybacks by S&P 500 companies continue to exceed $500 billion per year, the improved awareness and acceptance of Buyback ROI is encouraging.

However, we find that companies often struggle with translating the metric’s usefulness in evaluating the past to a forward-looking application. Buyback evaluation (or the lack thereof) is often disconnected from the rigorous analysis often associated with other forms of capital deployment. This disconnect likely reflects the common adoption of the pecking order theory that encourages a residual distribution policy. There are likely a few other motivations as well, but those can be saved for another article.

What’s the alternative? Until now, the best one could do was to suggest to execute buybacks in advance of share price increases. A higher future share price will help drive a higher ROI. But who doesn’t think their stock is cheap? Most managements believe their stock is undervalued and will rise in the future so we need a more rules-based process for evaluating buyback timing in order to deliver a desirable Buyback ROI.

We suggest that managers first perform a sanity check: (1) solve for the future earnings and multiple expansion scenario(s) necessary to deliver various levels of share price performance and subsequent Buyback ROI and (2) compare this performance to the past to get a sense of how likely it is that the company will achieve strong Buyback ROI.

Gregory V. Milano

 

 

To illustrate this exercise, consider IBM. If you assume the company maintains its current dividend yield of 3.8%, its share price would need to grow by 11.2% per year to achieve a 15% Buyback ROI (15%-3.8%, Buyback ROI incorporates the benefits of forgone dividends). This suggests a share price of $270 five years from now. IBM’s current share price is $159.

The consensus of the brokerage analysts that follow IBM is that it will deliver $13.60 of earnings per share over the next twelve months and 4% EPS growth over the long term. Compounding this growth rate until year five suggests a future EPS of about $15.88. The implied price-to-earnings multiple in year five would be the share price of $270 divided by the EPS $15.88, or 17.0x.

For IBM, a 17.0x multiple is higher than 96% percent of the historical observations over the last decade. The past is not always a good indicator of the future, but if IBM’s future valuations are at all like the past, this would suggest that buybacks are unlikely to deliver a 15% Buyback ROI at IBM.

There are other companies where there appears to be a better likelihood of achieving a strong future Buyback ROI. One such company is Southwest Airlines, which exhibits a relatively low current PE multiple, versus the company’s past, and a relatively strong consensus long-term EPS growth rate. To achieve a Buyback ROI of 15%, the implied year-five PE multiple is only at the 28th percentile against its past. It seems much more likely that Southwest can achieve a 15% Buyback ROI than IBM can.

Additional facets of the analysis can be added. For example, the analysis can also be done in reverse. Using IBM’s historical median PE multiple would imply a 9.3% Buyback ROI instead of the 15% that we solved for. A similar analysis for Southwest implies a Buyback ROI of 19.9% — more than twice that of IBM.

Variations of this exercise can be used to formulate a rules-based buyback framework that relies on a combination of important factors (company price multiples, earnings growth, probability of future multiple expansion, future cash needs and alternative uses, market valuations and trends, etc.). Such a framework will help increase the likelihood of a high buyback ROI by (1) providing a return-based focus for buybacks and (2) helping to improve timing.

These days, many executives say that investors put tremendous pressure on companies to buy back stock at all points in the market cycle. The approach described above can be used by managers to formulate and explain their capital deployment strategy. But it goes both ways. It can also be used by investors to apply more pressure when the timing seems advantageous and less when it doesn’t.

Gregory V. Milano, a regular CFO columnist, is the founder and chief executive officer of Fortuna Advisors LLC, a value-based strategic advisory firm. Joseph Theriault is a vice president.

 

 

This Forum program is open, free of charge, to anyone concerned with investor interests in the development of marketplace standards for expanded access to information for securities valuation and shareholder voting decisions. As stated in the posted Conditions of Participation, the Forum's purpose is to provide decision-makers with access to information and a free exchange of views on the issues presented in the program's Forum Summary. Each participant is expected to make independent use of information obtained through the Forum, subject to the privacy rights of other participants.  It is a Forum rule that participants will not be identified or quoted without their explicit permission.

This Forum program was initiated to address issues and objectives defined by participants in the 2010 "E-Meetings" program relevant to broad public interests in marketplace practices, rather than investor decisions relating to only a single company. The Forum may therefore invite program support of several companies that can provide both expertise and examples of leadership relating to the issues being addressed.

Inquiries about this Forum program and requests to be included in its distribution list may be addressed to access@shareholderforum.com.

The information provided to Forum participants is intended for their private reference, and permission has not been granted for the republishing of any copyrighted material. The material presented on this web site is the responsibility of Gary Lutin, as chairman of the Shareholder Forum.

Shareholder Forum™ is a trademark owned by The Shareholder Forum, Inc., for the programs conducted since 1999 to support investor access to decision-making information. It should be noted that we have no responsibility for the services that Broadridge Financial Solutions, Inc., introduced for review in the Forum's 2010 "E-Meetings" program and has since been offering with the “Shareholder Forum” name, and we have asked Broadridge to use a different name that does not suggest our support or endorsement.