When is a buyback a good buyback? by James Faulkner

With many companies facing a dearth of new investment prospects in an environment where borrowing costs are at historic lows, share buybacks have become increasingly popular as a means to push earnings higher. In theory, buybacks can be good news for investors. A company that uses excess funds to mop-up shares on the open market can reduce the overall share count, thereby giving each remaining investor a proportionately larger stake in the company. All things being equal, earnings per share will increase. However, there are several pitfalls of which investors need to be aware.

Investment theory dictates that managers should only consider share buybacks when the they offer the greatest potential return for shareholders – i.e. a better return than it could get from investing in new market and/or projects, growing the brand profile, streamlining the business and such forth. In addition to this, they should only be conducted when management believes the shares are undervalued.

If this is not the case, then investors would be better served by a dividend payment. Clearly, it makes no sense for a company to use shareholders’ cash to buyback shares for £15 when they are only worth £10 – the cash should be returned to shareholders so they can reallocate it effectively. It follows that share buybacks can often be a sign that a company’s shares may be undervalued.

The next point to make is that although buybacks increase EPS, this doesn’t automatically assume that the company’s shares will be re-rated, as many investors seem to assume. Let’s not forget that the company has to spend its own cash to acquire the shares that are to be cancelled. In doing so, it alters its capital structure, and the market will adjust its valuation accordingly. If the borrowed money is used – as is currently popular – this can raise the risk profile of the company and potentially destroy shareholder value. Aside from the increased temptation to take advantage of low interest rates, managers often use borrowed money to buyback shares in order to fend off a predator. This helps to raise the share price whilst gearing up the balance sheet to trash the prospective acquirer’s calculations.

When is a buyback a good buyback?

One very shrewd operator when it comes to share buybacks was actually one of the pioneers of the activity in the UK: Next (NXT). In his annual report to shareholders for 2013, Next CEO Lord Wolfson outlines his six golden rules of share buybacks:

“1) Share buybacks must be earnings enhancing and make a healthy Equivalent Rate of Return (see below).

2) Only use the cash the business does not need. NEXT has always prioritised investment in the business over share buybacks.

3) Use surplus cash flow, not ever-increasing amounts of debt. We have never allowed our share buyback programme to threaten our investment grade credit status and will not do so going forward.

4) Maintain the dividend at a reasonable level through growing dividends in line with EPS. NEXT will continue to increase dividends in line with EPS.

5) Be consistent. NEXT has been buying shares every year for more than 10 years, reducing the shares in issue by more than 50%.

6) For share buybacks to be an effective use of shareholder cash, the core business must have the prospect of long term growth.”

Wolfson also very helpfully provides a detailed illustration of the logic behind Next’s buyback programme in action. In order to assess whether or not a share buyback is desirable, there are two measures Next looks at.

“The first is the earnings enhancement of a buyback when compared to the enhancement to earnings from keeping the cash in the bank and earning interest. The second is the comparison between the earnings enhancement of a buyback compared to the return that would have to be achieved from investing the cash in an alternative investment, the equivalent rate of return (ERR).

With long term borrowing rates for NEXT at around 4%, a share buyback of £250m at £40 would be 2.5% earnings enhancing. The problem with this method of assessing buybacks is that at low interest rates buybacks remain earnings enhancing beyond £60, so we consider the equivalent rate of return measure to be more helpful.

The tables below set out the maths used to calculate ERR. The top table shows the enhancement achieved from acquiring £250m of shares at £40, which is 4%. The second table shows that if we were to increase our profits by 4% we would have to invest in an asset yielding 10%. Given that share buybacks carry no additional operational risk, the returns at 10% remain very attractive.

The graph below shows how ERR falls as the share price rises. As the yield approaches the Market’s expected return on equity (say 8%), the buyback becomes less attractive. If the returns dropped much below 9% we would become less enthusiastic, so to a certain extent the share price provides a natural moderator of a disciplined buyback programme.”

Wolfson’s golden rules should actually be required reading for all company boards. Unfortunately however, there are plenty of companies that have not been as disciplined as Next when it comes to their share buyback policies. Should the world tip back into a renewed downturn – as some very astute market operators are predicting – we shall see exactly who has been swimming naked.