Hi I'm Jimmy in this video
we're looking at stock buybacks how
they work and if they're really a
good thing for us investors
and what should we watch for.
If we're analyzing a company that is
doing a stock buyback.
OK. Let's jump right in.
So ultimately a stock buyback
is when a company buys shares
of their own company generally
from the public.
Now there are a handful of different
ways to do a stock buyback but the
most popular method is known as an
open market share buyback.
And basically there the company
declares how much of the shares
they're allowed to buyback and
then the company gets to decide when
and if they're going to actually buy
those shares on the open market.
OK. So this the most popular
method so let's just assume that
this is a method that's happening.
This brings us to the real question
is are stock buybacks a good
thing or a bad thing.
Because clearly they've been
happening more and more in recent
years.
Now this is the information that I
could find from different sources
some of them were conflicting but
this is I would say the average
of what I could find and the green
bars ultimately I took from Goldman
Sachs and it was an article talking
about they estimated that there
would be 940 billion dollars worth
of buybacks in 2019.
Now broadly speaking investors tend
to like buybacks because
generally buybacks are believed to
increase earnings per share.
Here's how.
Let's pretend that a company has
5000 dollars in profits
and then they have a thousand shares
outstanding.
Well we take that five thousand and
divide it by the thousand and
therefore they have an earnings per
share of five dollars per share.
Simple enough but let's say the
company wants to buyback 100 shares
from the public.
Well now they're only 900 shares
outstanding.
So the theory goes that we
will have the same net income.
So earnings per share will jump all
the way to five dollars and 56
cents.
Sounds like a pretty good thing the
stock price in theory should rise.
So we know that with this formula.
Well we know that shares outstanding
are going to fall.
That's the nature of a buyback.
But the assumption is also that
net income it will stay
the same. And that's not always
true. Sometimes the buyback
itself can actually make net
income fall to determine
this. The first question we need to
ask is how is the share
buyback being funded.
Are they using cash that's sitting
on the balance sheet or are they
borrowing money to initiate this
particular buyback.
Let's start with what it would be
like if they were borrowing money.
Well at first our thought might be
this is crazy.
Of course borrowing money to do a
share buyback is a bad thing.
But it actually depends on
a few different things.
So.
We have the same company we're going
to stick with our same example.
This time we're going to add a few
details. The price
per share to buy the stock
on the stock market is one hundred
dollars per share their profit for
the past year is still five thousand
dollars and earnings per share.
We're going to bring it back to five
dollars per share.
Same 1000 shares outstanding.
So one thing I'm sure many of us
know is that if we take the price
per share and we divide it by the
earnings per share we get the P E
ratio.
In this case our PE ratio is about
20 x Okay.
Simple enough but if we reverse
this math and we take the earnings
per share and we divide it by the
price per share or we gets what
known it we get what is known as
the earnings yield.
Another option would be to simply
take the inverse of the PE ratio.
So in our case our P E 20.
So we take one divided by 20.
You end up with in our case in
earnings the other 5 percent.
So the key for us and this is the
important part is that if
the earnings yield is higher
than the after tax cost of debt
than earnings per share will move
higher after a share repurchase
with debt.
But if the cost of the borrowing
is greater than the earnings
yield then the earnings per share
will actually move down
after the car after the share
repurchase.
Let me do a quick illustration.
So the company that we're analyzing
wants to buy back one hundred shares
and since those shares are one
hundred dollars per share it's going
to cost them ten thousand dollars.
Now let's pretend that they want to
borrow that ten thousand dollars and
the after tax cost of debt is going
to cost them seven percent.
OK fair enough.
So their actual interest
expense on that ten thousand dollars
will be seven hundred dollars per
year. That's how much we're gonna
have to pay in interest.
That will reduce their net income
by seven hundred dollars bringing
their profits now to forty three
hundred dollars per year five
thousand minus seven hundred.
But they also have less shares
outstanding. So now they only have
nine hundred shares outstanding.
So if we take that forty three
hundred divide by 900
share earnings per share actually
fell to four dollars and 78 cents.
That is simply because the cost
of debt was higher than the earnings
yield. Now the earnings yield was 5
percent. So had the cost of debt
been 5 percent would have been no
change to earnings per share.
What does this tell us.
This tells us the price that the
company pays is crucially
important.
If the company pays 100 miles per
share they have 5 percent earnings
yield but if they were to pay 50
dollars per share they would have
been much. Higher earnings yield the
same 7 percent debt
would have been profitable for them
because they would have got their
shares at a better deal.
Okay now what if the company wants
to use cash that it already has on
its balance sheet for the stock
buyback instead of debt.
Once again the same concept applies
although cash transactions can be a
bit trickier to quantify.
So let's take the very same earnings
yield. So we have an earnings yield
of 5 percent.
So our question is was
that cash earning more
than 5 percent or did it have the
potential to earn more than 5
percent.
If it was well then the
profits would fall
and earnings per share would fall.
But if it wasn't well earnings per
share would rise.
And that's really what makes this
the trickier to quantify with cash
because the company may not tell us
what they were planning to do with
that cash.
Most of the time earnings per share
is going to get stronger with a cash
buyback especially when we compare
it to buyback financed
by debt but
our buybacks a good thing assuming
they're all cash buybacks.
Well clearly there's only a few
things that a company can do with
its cash.
They can do a share buyback.
They can pay out a dividend.
They can reinvest that cash
into the company or perhaps they can
go ahead and make an acquisition.
I think the real pushback with stock
buybacks is that this
implies that the company can't
find anything better to do with the
cash that they're buying back their
shares with.
In our example here well
we have an earnings yield of 5
percent.
And if the company can't
earn more than 5 percent with that
cash sure it makes sense
to return to the shareholders.
But they can also return it in the
form of dividends our dividends
better. Well it depends on the
investor. Take Berkshire Hathaway as
an example.
Warren Buffett never does dividends
but he is willing to do stock
buybacks every now and again
and a lot of the reasoning behind
this is that he believes
that his shareholders
trust him to allocate their
cash as efficiently
as possible and in theory
paying a dividend will simply
put the responsibility back in
the shareholders hands to reinvest
that cash.
In my opinion capital allocation
is one of the most important things
it's one of the biggest responsibilities
of an organization.
Take our company as an example.
It's trading 100 hundred hours per
share.
Five dollars in earnings.
What does that hundred dollars were
to fall the market would a crash or
something and it fell all the way
down to twenty five dollars per
share.
Well now we have an earnings yield
of 20 percent.
Suddenly a stock buyback is a very
very smart thing to do.
They're getting a fantastic return
on their capital.
They're investing in themselves.
That would help all of us
shareholders assuming we all own a
piece of this company.
To me that makes a lot of sense.
So if the company can't find a good
acquisition or perhaps they feel
that they have too much cash to
continue to grow organically
so reinvesting it doesn't make
sense.
Well a dividend or buyback
could make a lot of sense.
Now personally I'm
generally a fan of buybacks.
There is some tax advantages to it
you get taxed on dividends generally
and you might not.
And buybacks although buybacks on a
lot in all countries.
But broadly speaking
a cash buyback can be
quite useful to our company.
So going back to our example for a
moment. Well if the cash
wasn't doing much of anything when
they did the stock buyback perhaps
it was just seeing a money market
account or something like that.
Well net income would stay broadly
the same.
Earnings the shares the shares
outstanding would fall to 900 shares
outstanding and therefore
earnings per share would jump
by more than 11 percent.
So we assume that the stock
price would jump as well.
But by how much.
Now one thing to keep in mind is
leverage. So when a company does
a stock buyback.
So if we take the very popular
financial leverage ratio known as
debt to equity well here
let's pretend that we have assets
of fifty thousand dollars
liabilities of thirty thousand.
Well this give us this will give us
equity of twenty thousand to
calculate debt to equity.
But we take the 30 thousand in debt
or liabilities and we divide that
by the equity of twenty thousand
and we get a financial leverage
ratio of one point five.
Well once we do the buyback well
assets fall because cash would have
been spent assets fall by ten
thousand dollars.
Equity falls by ten thousand
dollars. That keeps the balance the
balance sheet in balance and
our financial leverage ratio jumps
all the way to three from one
point five to three.
Now I bring this out because higher
companies with higher leverage tend
to traded a smaller P E multiple.
All else being equal.
So in theory yes earnings per share
will jump but that doesn't guarantee
that the stock price is going to
jump by the same amount.
Our company was trading at 20 acts
for a PE multiple that but that's
when they had a debt to equity ratio
of one point five.
Now the debt to equity has increased
to three.
Well perhaps they won't trade a 20.
Maybe they traded 18 or 16 or
19.
It depends on what the market is
going for at that time.
So at the end of the day I like
buybacks in certain situations
not broad that I don't think that
they should be used as much as it
being used right now.
Not sure that every situation is
appropriate for him.
But what do you think.
Do you think that buybacks are good
at adding shareholder value.
Do you agree with me that what we
need to do is analyze each one in
isolation and say Does this buyback
make sense mathematically.
Let me know what you think in the
comments below.
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