Friday, April 15, 2016

The Net Profit Test: Comparing Buybacks to Investment

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
April 13, 2016

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