Corequity Valuations: February 2016

The goal in buying back shares in a company is to increase the growth rate of the earnings per share. However, there is no benefit accruing to the growth in Net Profit which is unaffected. This analysis calculates the after tax return on the funds used in the buyback program that would be necessary to grow the Net Profit at the same rate as the EPS. Clearly this is a desirable goal and the rates required are surprisingly low which suggests that the buyback programs are a poor use of resources.

Imagine if the shareholders of Bed Bath & Beyond were asked a question in 2008.

“Would you prefer to have growth in Net Profits of 9% or 17% in the next seven years, assuming that the growth in earnings per share would be the same?"

Surely they would have elected the higher net profit (i.e. more money) and you would think that management would too but you would be wrong.

In the period between 2008 and 2015, BBBY bought back 38% of their outstanding stock at a cost of over $6 billion dollars. (That turns out to be equal to the total net profit during the entire period.) We calculate that the company would only have needed to earn 6.9% after tax on those funds to grow their Net Profit at the same rate as the earnings per share which was 17.3%. In 2015, the difference in Net Profit would have been $1,300 million vs $800 million. That is $500 million more in one year (over 60% and growing!) if management successfully reinvested the funds at under 7% instead buying their own stock.

Here is the calculation[1] -

I should point out here that I don’t think that BBBY is a bad company but rather one of many that are following a very bad practice.

As shown in the following table, BBBY is not alone. Most of these companies[2] would only have to earn a fraction of what they achieved to have made significantly more money for their shareholders. This is shown in the last column (MP/NP) where the range of missed profits is from 8 to 101% of Net Profits in 2015.

Home Depot (HD) is another good example. They bought back 27% of the shares outstanding in 2008 at a cumulative cost of $29 billion. EPS grew at 16.8% while Net Profit grew at only 12.5%. Had they reinvested those funds at 6.3% after tax, they would have had grown their Net Profit at the same 16.8% and earned close to $2 billion more in 2015 Net Profit. That is close to a third more than they actually earned.

One possible explanation is that management is motivated to increase their incentive remuneration by increasing the growth of earnings per share without risk. However these companies justify their buyback programs, it is clear that most would need only a small ROI to enhance the shareholders’ real returns. Seven out of these 12 examples have a required return to balance EPS growth of under 7 % with Allstate (ALL) and Kimberly-Clark (KMB) being the lowest.

Alternatively, in cases like some Banks, the reason might be that they can’t re-invest at even the minimum required return. However, this explanation would be just as detrimental to the stock.

I recently was with the CEO of an international firm that employees 70,000 persons world-wide, has a market cap of $24 billion and whose stock gained 330% in the last 7 years. I asked him if his company had bought any stock back and his answer was: “Non - it is better to finance growth which will generate long term returns.”

corequity.blogspot.com

robertlcolby@gmail.com

Gretchen Morgenson's NY Times article on this research report

[1] Data: Value Line

[2] These companies were selected from the holdings of the Buyback ETF (SPYB) for their consistent buyback programs during the period of 2008-2015.