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Share count reduction - permanent shareholder value creation

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January 16, 2014 – Comments (5) | RELATED TICKERS: IBM , BLL , GPS

This is another blog post on share buybacks.  Evil share buybacks.  Executive teams' method of hiding stock compensation.  CFOs' secret way of artificially boosting EPS through financial engineering.

The sad fact is that because many large corporations' financial departments have given buybacks a bad name.  And just maybe, rightfully so.  But when done effectively, share buybacks are one of the safest, most powerful methods for companies to return value to shareholders.

So, how are share buybacks done effectively?  By diluted share count reduction, of course!

When I read a Bloomberg, WSJ, The Motley Fool, or Reuters article on a company's quarterly performance, I commonly see items on revenue growth, net income growth, and EPS growth.  But I rarely see anything on buybacks.  Even if the author goes above and beyond the relative call of duty to report the amount spent on buying back shares, they almost never go as far to tell the reader how many shares - nominal or % - were actually reduced.

But share reduction is one of the most important means of increasing shareholder value.

Let's take 2 theoretical companies.  We'll analyze their EPS after 10 years.  Both companies start with $1M in earnings and 100K shares outstanding, yielding $10 EPS.  Company A increases its earnings 10% every year, but its share count stays constant.  Company B decreases its share count by 10% every year, but its earnings stay constant.  (So from an earnings/share perspective, for one company we increase the top line by 10% every year, and for the other company we decrease the bottom line 10% every year.)

After 10 years, the comany with the earnings growth will be generating $25.9 EPS.

The company with flat earnings, but 10% reduction in shares per year: $28.7 EPS.

I realize this ignores the fact that the second company had burn cash in order to reduce those shares, but the counter argument is that the first company likely had to invest a lot of cash in order to generate 10% earnings growth per year.  (That leads to another discussion on the wonder of high ROA companies...)  Also, when a company spends $1B on share buybacks, its incredibly easy to analyze exactly how impactful those buybacks are.  But when a company spends $1B on an acquisition or a new investment that channels into CapEx - I don't have a clue how successful that investment is going to be.

I realize my 2 company example is likely far too simple to apply directly to a real world perspective, but the purpose of this post is to try to convey that from an earnings per share (or dividends per share) perspective, reductions in the amount of total outstanding shares can be very effective.  The ideal scenario is to find a company that can grow the numerator AND shrink the denominator simultaneously.  But by focusing solely on the numerator, you might be missing out.

Here is a list of strong-branded, stable, proven companies that have wonderful buyback programs in place (I just so happen to be long all of these comanies).

XOM, IBM, GPS, COH, TGT, BLL, DPS

5 Comments – Post Your Own

#1) On January 16, 2014 at 7:17 PM, ElCid16 (93.74) wrote:

Here's an article differentiating share buybacks from actual share reduction (ignore the part about AT&T's P/E of 30 at the end, though):

http://www.wallstreetdaily.com/2013/04/03/buyback-kings/

 

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#2) On January 16, 2014 at 11:35 PM, Valyooo (99.43) wrote:

I like buybacks in theory more than in practice.

 

So, they're not double taxed like dividends are. Great! Plus, who knows the company better than the insiders?  Surely they will be able ot buy at best prices.

 

That's the theory.

 

From witnessing buybacks over the last 5 years (sorry, that's my active entire investing life), management seems to buy at any price- and more often than not, at the tops....AND they get front-runned (Front-ran?)  So just like it would be unwise to go willy-nilly buying stocks at any price just because you have extra cash as an investor laying around, I don't like that companies do the same thign and get praised for it.

 

On the other hand, JPM is great at buybacks.  Jamie Dimon is an excellent bank-stock buyer, and he strategically waits for good entries to buy the stock back...that's what I like to see, but unfortunately it is the exception, rather than the rule. 

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#3) On January 16, 2014 at 11:40 PM, Valyooo (99.43) wrote:

P.S. Glad you're still around.  I don't come here much anymore but you are one of the few CAPs members who I enjoy reading what you have to say.

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#4) On January 17, 2014 at 12:20 AM, ElCid16 (93.74) wrote:

Valyooo - thanks for the kind words.

I know exactly what you mean regarding botched attempts at buybacks.  During good operational years when companies are flush with cash, they feel the need to burn through that cash via buybacks.  Unfortunately, during good operational years, they're also trading at premium multiples, meaning the buybacks don't go very far toward share count reductions.

That's why I place a much greater focus on share count reduction, rather than actual buybacks.  Companies that are really good at share reduction (~4% reduction per year) don't try to time the market, and they don't simply wait until they have tons of cash to start buying stock.  They've made it an operational practice to do it consistently.

Take ROST, for example.  These guys have been buying back stock, year in and year out, like clockwork.  And the results have been phenomenal.  I've got financial data on ROST dating back to 2001.  Since that time span, they've grown net income 14.7% per year (CAGR).  But because of the consistency with their buybacks, they've grown EPS 18.5% per year.  You're a smart guy - I don't need to tell you that the incremental 4% bump from share count reduction does wonders for shareholders.  And the dividend per share CAGR over that same span: 24.6%.  Assuming the trend continues, their dividend, per share, could be 10x what it is right now in less than a decade!

By the way - I've only been at this investing thing for about 6 or so years now.  (I'm at the ripe old age of 30.)  I got my start, right here, on the motley fool (and my CAPS account shows it - I can't believe some of the picks I made 3-5 years ago).  It all started with some one-off article on the wonders of compounding.  I feel like the value I get from CAPS drops a bit more every year, but I almost feel an obligation to stick around.  :)

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#5) On January 17, 2014 at 8:48 AM, Valyooo (99.43) wrote:

I know what you mean. I'm 24, and I met griffin416 on here. Turns out he lives close to me....I met him in real life 4 years ago, and last year we started our own investment fund. We only have 120k AUM as of right now (it's a side job) but I would say the vast majority of my learning came through these blogs. I find little to no value anymore on here but I can't seem to let it go

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