Share Buybacks: When should a company consider a Buyback?

Share buybacks are a common practice for companies with more cash than they know what to do with to return it to shareholders. Buybacks are more common in the Unites States than in Australia since Australia's taxation system gives a more beneficial treatment to dividends by franking credits (i.e., a refund of the tax that the company has already paid on that cash).

Share buybacks are one of several options a company has when deciding what to do with its profits and cash flows. These options are:

• Reinvest the cash back into the business for growth
• Pay the cash out as dividends
• Buy back stock
• Make an acquisition
• Leave cash in the bank account or in money market funds

Let's briefly look at each of these options and when a company should utilise them.

Reinvesting in the business

The company should invest in the business if it is a growing business and/or growing industry and the company can earn a high rate of return on the cash by doing so. The return comes in the form of higher profits in the future. This can be quantified calculating the incremental return on capital (change in operating income divided by the change in total capital). If the company can earn a high return on incremental capital this should always be the preference.

Dividends

A company should pay the cash out as dividends if it has reached or is approaching the mature stage of the business lifecycle. When a company or industry is mature, it is very difficult to earn a high incremental return on capital because there is little further growth that can be achieved regardless of investment. The investment might normally come in the form of marketing spend or research and development. If a shareholder can likely earn a higher return on the cash by investing it in something else, it should be paid out as a dividend.

Acquisitions

The case for making an acquisition should be straightforward, however, history has shown that acquisitions are not always the best use of shareholders money. Any time you have seen a company announce an impairment to their goodwill, this is essentially management admitting defeat; that the acquisition they made in the past has not met expectations. There are technical ways this is quantified by accountants that I won't go into. Some excellent reasons to make an acquisition are when it complements the existing business in terms of increasing scale, adding technical capabilities that would be more expensive to learn or develop, or to take out a competitor (so long as you don't catch the ire of the antitrust regulators).

Leave it in the bank

There are very few reasons to leave cash sitting in the bank without a purpose. Obviously, a company should always leave enough in the bank for working capital purposes, general spending, and as a buffer, but it should not more than it needs. Any management team that does this will increasingly invite activist investors to launch raids on the company targeting the cash for their own use.

Share buybacks

Finally, a company should buy back its stock for the same reason that any investor should buy that same stock: when it perceives it to be undervalued by the market. Shareholders benefit from share buybacks for the same reason that equity raises can be detrimental to the investor (if not done intelligently, which could be its own article): dilution. Dilution means more shares are issued so the profits must be shared around more investors. Think of it like a pizza being split into 8 pieces because there are 8 people at the party, but then 2 more people arrive so the pizza now must be cut in 10 pieces: everyone will now eat a little less as they have a smaller share of the pizza.

Buying back stock is like paying a few friends to leave the party. If the pizza cost $10, each of the 10 slices are worth (in management's estimate) $1 per slice, at what price would it make sense to do so? Clearly, if you could get away with it, you would like to pay as many friends as possible less than $1 per slice to leave. The same is true with share buybacks. If management estimate the value per share of a company to be $1, then it makes perfect sense to buy back stock because this will increase the value per share of each dollar of earnings.

Do all management teams use this framework?

Unfortunately, this is not always what is seen in reality. Management teams often have their own agenda and do not always act in the best interests of shareholders in mind when making capital allocation decisions. One consideration is in regard to acquisitions in particular. Investors need to be very wary of companies that make acquisitions, especially if they make several per year. The more acquisitions, the more risk that not all of them pay off. This can sometimes be an exercise in a CEO wishing to increase the size of the company so that their pay packet will increase due to being responsible for a larger organisation. This is a clear case of agency risk and would benefit the CEO more than shareholders. I'm not saying this is all acquisitions, but it's just a comment to show an incentive to use capital on acquisitions, rather on another form of allocation that would better benefit shareholders, as discussed above.

There have been some excellent acquisitions in recent years on the ASX. Altium's acquisition of Octopart, and Aristocrat's acquisitions of Big Fish and Plarium come immediately to mind as some of the better ones, which have returned many times the initial investment to investors.

Summing up

Capital allocation is one of the most important parts of the role of a management team. All the best companies in the world have become so since they have leaders that have understood where their shareholders' capital is best deployed for the highest return. The managers with their incentives aligned with shareholders (which generally takes the form of a large ownership in the company), are the most likely ones to make good allocation decisions. Use the above framework to analyse the capital management decisions management make and when you see CEOs making decisions that go against this, question what impact this might have on future long-term returns of the business.
Written by Luke Durbin
Lead Portfolio Manager
Oracle Investment Management
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