# The Net Profit Test asks the question: what rate of return is required on investing the buyback funds to grow the Net Profit at the same rate as the Earnings per Share (EPS) grew due to the buyback. If it can be shown that a low rate of return would equalize the growth between Net Profit and EPS, then the probability is high that the company would earn more money by investing.

The return that a
shareholder receives when a company buys back its stock occurs at the time of
purchase and only then. It is because the Net Profit is being divided by a
fewer number of shares (i.e. decimating the denominator). This is contrasted to investing the same
funds (i.e. enhancing the numerator).

In this example,
the company is assumed to have bought back 10% of its shares at 10x earnings.
With 10% fewer shares, the EPS is increased by 11% at the outset.

The alternative use of the buyback funds
is assumed to be an investment that earns 3% in the first year, 8% the
second and 10% thereafter. As shown in the graph, the annualized
returns crossover occurs in the second year and from that point on the investment
is the better asset allocation decision.

Surprisingly, the return
generated by buybacks is independent of the price paid for the shares. Instead,
the cost of the decision is measured by what the funds could otherwise have
achieved if invested. In the above example, if the buyback was done at $7.20 a share, the Net Profit under the two scenarios would be equal after 8 years. However,
with the buyback at $10.00, the investment would have generated 40% more
in Net Profit.

(As a corollary, the higher the investment
return, the lower the buyback price that can be justified.)

Our analysis of 25
companies with aggressive buyback programs from 2008 to 2015 shows an average P/E
of 15x earnings. It is also evident that
most companies spend more on buybacks when their P/E’s are at the upper end of
their range suggesting a higher dollar weighted P/E.

My conclusion is
that few buybacks in recent years come even close to meeting the Net
Profit Test. Given that S&P 500 companies alone have bought back over $2
trillion of their stock since 2009, you have to be in awe by the scope of
this misallocation of corporate assets and its consequences for the economy.

© 2016 Robert L. Colby

corequity.blogspot.com

April 13, 2016

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