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
May 5, 2017 | CFO.com | US
Almost six years ago, we introduced Buyback ROI on CFO.com in an
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
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
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.