What’s Your Return on Buybacks?
Managements may be biased in favor
of their own companies' valuation.
Gregory V. Milano
June 3, 2011 | CFO.com | US
During informal discussions after a recent presentation to a company’s
investors and analysts, I stood with the CFO and watched in dismay as
he was barraged with questions about buybacks. He and his CEO had
presented a strong growth strategy and were commended for it, yet the
questions were disproportionately about share repurchases and not the
company’s organic and acquisitive investments. Sometimes investors
seem to overly fixate on what they perceive to be the benefits of
In other cases, senior executives seem to overemphasize share
repurchases, often because they boost earnings per share (EPS).
Interest rates are so low that cash in the bank contributes zilch to
net income. By distributing excess cash via repurchases, EPS increases
because net income is divided by fewer shares. I’ve heard one CFO say
that more than half of his company’s EPS growth in recent years came
from buybacks — but is that as valuable as EPS improvements from
revenue growth and margin improvements?
Do buybacks help improve a company’s total return to shareholders?
What sort of return do investors get from buybacks?
Those are critical questions, since after a lull during the financial
crisis corporate buybacks are on the rise again in a big way. During
the previous buyback wave from 2004 through 2008, the members of the
current Standard & Poor’s 500 repurchased more than $1.80 trillion
worth of their own shares, which represents $90 billion per quarter.
In 2009, buybacks declined 63% from that five-year average. In the
first quarter of 2011, however, buybacks are back up to $85 billion.
The recent torrent of buyback announcements indicates we’re in the
midst of another wave of heavy share repurchases.
So how do buybacks affect share price performance? Our research on the
buyback habits of 461 of the current S&P 500 during the five-year
buyback wave from 2004 through 2008 and the aftereffects on share
prices demonstrates, for one thing, that investing in them may not
yield as much value as investing in a company’s business.
One observation based on the research is that the 29 companies that
did not repurchase any stock during this period delivered median total
shareholder return (TSR) of positive 40%, while the overall S&P 500
index was down 19%. That was likely caused by differences in the
investment opportunity set.
Those companies with great investment opportunities don’t buy back
shares, yet they have strong TSR. It may not mean that the presence or
lack of buybacks caused the difference, but the result certainly
reinforces the notion that investing in the business is a better way
to drive the share price than buybacks. CFOs must be careful not to
allow buybacks to keep the company from making good investments in the
A second observation is that buyback timing doesn’t seem to follow the
“buy low and sell high” paradigm. Indeed, as shown in the graph below,
buyback timing seems to follow a “buy high” rather than a “buy low”
course. That is critical, since many companies explain their buyback
programs by claiming their shares appear undervalued. Perhaps
managements are prejudiced in their assessment of their own company’s
We also tested the return on investment (ROI) of buyback programs by
using both a straight gain-or-loss methodology and an internal rate of
return (IRR) approach.
Overall, these companies repurchased $1.80 trillion worth of their
shares from 2004 through 2008, and the shares would have a market
value of $1.96 trillion as of April 2011, resulting in a gain of $160
billion. The top gains were registered by IBM, Exxon, and Oracle, with
the top 10 accounting for 90% of the gains.
The bottom 10 buyback companies repurchased $230 billion worth of
shares at prices that averaged 94% higher than their prices are today.
Not surprisingly, this group included many financial institutions,
with the top losses registered by Bank of America, Citigroup, and GE.
Do such results represent a desirable use of capital? We applied an
IRR approach to examine the average annualized ROI on these
“investments.” We examined the cash outflows each quarter from 2004
through 2008 and estimated the number of shares repurchased at the
average share price of the quarter. We then calculated an ROI relative
to what those shares would be worth at the April 2011 share price. The
top ROI was Netflix, with $300 million in repurchases now worth nearly
$2.7 billion, for an ROI of 94%.
The median buyback company delivered an ROI of 3%, and three out of
every four companies delivered a buyback ROI of less than 10%, a
common hurdle rate for capital investment. For companies with rising
share prices, buybacks amplified the increase. But for those with
declining share prices, buybacks exacerbated the decline. In many
cases, the only happy shareholders were the ones who sold shares back
to the company when the share price was higher.
Given common buyback strategies, such poor results are almost
inevitable. Many companies employ a pecking-order capital-deployment
strategy in which cash in excess of reinvestment needs is distributed
via share repurchases. While this strategy seems sensible, it leads to
buying back more shares when the market value has increased
significantly in response to stronger cash flows. This
capital-deployment strategy seems flawed.
What are better buyback strategies? There are two reasonable choices.
The first is to stop distributing capital based on availability and
shift to a steady buyback program that distributes a consistent sum of
cash every quarter. In effect, it means buying back more shares when
prices are low than when they are high. That may be hard to stomach in
a financial crisis, and may attract activist investors who abhor
rising cash balances during good times.
The second is to continue with the pecking-order strategy but shift
the variable portion of the distributions to a changeable special
dividend. That way leverage and cash balances can be maintained while
avoiding the typical propensity to buy back more shares when they are
expensive. Either way, the shareholder will be better off.
Gregory V. Milano is co-founder and CEO of Fortuna Advisors LLC, a
strategic advisory firm, and a regular columnist for CFO.com.