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Creating value with confused buyback arithmetic

 

Additional reports and research addressing the use of corporate capital to repurchase stock can be found in the "Stock Buyback Policy" reference section of a Forum project that had addressed a company-specific example, and in the user-input models developed in a recent Forum workshop for Buyback Analysis.

 

Source:  Bloomberg, August 7, 2018 commentary

BloombergOpinion

Finance

Buying Your Way Back to Riches

♦ ♦ ♦


By Matt Levine

‎August‎ ‎ 7, 2018, 11:19 AM EDT

 


Matt Levine is a Bloomberg Opinion columnist covering finance. He was an editor of Dealbreaker, an investment banker at Goldman Sachs, a mergers and acquisitions lawyer at Wachtell, Lipton, Rosen & Katz, and a clerk for the U.S. Court of Appeals for the 3rd Circuit.

Read more opinion

 

People are worried about stock buybacks

The way a stock buyback works is:

1.  You have a company worth $1,100, with $100 of extra cash on hand.

2.  It has 110 shares outstanding.

3.  Each share is worth $10.

4.  You decide you don’t need all that cash and that you should give it back to shareholders who want to sell.

5.  You buy 10 shares for $10 each, using the $100 in extra cash.

6.  Now you have 100 shares outstanding, no extra cash, and a company that is worth $X.

What is X? In this schematic description it seems like it should be $1,000. You had a company worth $1,100. It gave $100 back to shareholders, in exchange for nothing. (In exchange for their shares, yes, sure, but as far as the company is concerned those aren’t a thing.) $1,100 minus $100 is $1,000. There would be something odd about getting any different answer. Before the buyback the shareholders, collectively, owned $1,100 worth of stuff. (Their stock.) After the buyback the shareholders, collectively, owned $X + $100 worth of stuff. (The cash, plus the remaining stock.) If $X is more than $1,000, then the buyback—just shuffling around ownership of the $100—created value; if it’s less than $1,000, then it destroyed value. In an efficient world you shouldn’t be able to create value out of thin air just by changing who holds on to some cash.

But we don’t live in an efficient world and in fact there is no reason to assume that buybacks reduce the value of their firms by the amount of the buyback. They might reduce it by more than the amount of the buyback: If the buyback is an admission that the company is out of ideas and can’t do anything productive with investor cash, then that admission will reduce the expected value of the ongoing business. (This is, you’d expect, uncommon, because if the buyback reduced the stock price why would the managers do it?) Or they might reduce it by less than the amount of the buyback: If the buyback is a sign that management is focused on capital efficiency and shareholder value, and if the business is otherwise doing well and making a lot of money and investing significantly in research and development, then perhaps it can create more value by giving the extra money to shareholders than it can by just hanging on to vast piles of cash. If the buyback is not an admission that the company is out of ideas, but rather a celebration of the fact that even after lavishly funding all of its ideas the company has more money than it knows what to do with, that’s good. Making too much money is a good problem! In that case, the buyback really might create value out of thin air.

If that’s true, then the buyback won’t reduce the value of the company by the amount of the buyback. It will reduce it by some lesser amount. It might even—and it is hard to tell, hard to disentangle the effect of the buyback from the effects of announcements of good news, etc.—but it might even leave the value of the company unchanged. In my example, the company would be worth $1,100 after the buyback, and the shareholders would get a “free” $100. The implication there would be that the $100, when it sat on the company’s balance sheet, was worth $0: The company had no productive uses for it, and the market expected it to just waste it on garbage, so returning it to shareholders created $100 of pure windfall value.

I suppose there is no reason that the buyback couldn’t even increase the value of the company—it could be worth $1,200 after the buyback, even after taking out the $100 in cash—but that would be a little silly. The implication there would be that the cash on the company’s balance sheet was worth less than zero, that the market expected the company not just to utterly waste the $100 but to waste it in a way that destroyed additional value. I suppose in small quantities and at some margins this could happen, but it can’t really scale. If you have a $100 billion company and spend $10 billion buying back stock and that—that alone—makes the company worth $110 billion, then you’ve created a perpetual-motion machine. You can borrow money to buy back all the stock except for one share, but that share would be worth $200 billion. (Then you sell a 50% stake in that share, use it to repay your loan, and bang, free money. I realize the math here is a bit imprecise.)

Anyway here is a claim that Apple Inc. reached its $1 trillion valuation by buying back stock:

Apple’s recent success on Wall Street isn’t due to its technological innovations or its sleek products. Instead, its stock has been juiced by a record-breaking number of buybacks, in which the company buys shares of its own stock, causing the supply to drop and the price to rise. In May, several months after Congress passed a massive corporate tax cut, Apple pledged $100 billion to stock buybacks in 2018—and is halfway to that goal. With $285 billion in cash on hand, it can afford to buy even more.

Viewed over a period of decades, a number of products and achievements played a role in getting Apple to where it is today. But as the company’s profit margins have shrunk, stock buybacks played a crucial role in getting Apple over the trillion-dollar finish line first. This asterisk should be something of a scandal. Apple is the poster child of the current spate of stock buybacks, which are starving investment and exacerbating inequality.

I feel like … nope? As a matter of the “poster child” thing; Apple spent $11.6 billion on research and development in fiscal 2017, up from $10 billion in 2016 and $8.1 billion in 2015—a bigger two-year increase in R&D dollars than most other companies spend on R&D total. You should entertain the possibility that Apple’s vast research budget pays for the research that Apple wants to do, and that some of the unusable excess gets returned to shareholders in the form of buybacks. 

But mostly nope as a matter of arithmetic. The theory here is essentially that if Apple had 220 billion more dollars—roughly the amount of buybacks it has done in the last six years—then it would be worth less money. It doesn’t sound especially plausible. Presumably Apple plus $220 billion would be worth at least, like, a dollar more than Apple alone? And if the buybacks work so well, why not do more? Why not sell off all of Apple’s businesses, use the money to buy back stock, and leave Apple as an empty shell with a reduced share count and a $2 trillion valuation?

There is a widespread view among critics, not only of buybacks but of financial capitalism generally, that it is all tricks and that the tricks are easy. This article is titled “Apple’s Stock Market Scam.” The idea is that investors are incredibly easily deceived, that stock prices reflect no reasoned judgments about a company’s business prospects, that gaming those prices is child’s play. It is a world in which investors are entirely unable to evaluate a company’s business, and can be tricked by devices—stock buybacks, non-GAAP accounting—that occur in broad daylight and are subject to frequent intense criticism. It would probably be very convenient for CEOs if they could increase their valuations that easily, but I suspect it’s not true.

♦ ♦ ♦

 


This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.


To contact the author of this story:
Matt Levine at mlevine51@bloomberg.net


To contact the editor responsible for this story:
James Greiff at jgreiff@bloomberg.net


 

 


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