- July 29, 2022
- Posted by: Ramkumar
- Category: Posts
How To Evaluate A Share Buyback
Over the last month, IT companies have announced to 𝐛𝐮𝐲 𝐛𝐚𝐜𝐤 𝐬𝐡𝐚𝐫𝐞𝐬, and companies’ share prices have increased after this corporate action.
𝐃𝐨𝐞𝐬 𝐁𝐮𝐲𝐢𝐧𝐠 𝐛𝐚𝐜𝐤 𝐬𝐡𝐚𝐫𝐞𝐬 𝐚𝐝𝐝 𝐯𝐚𝐥𝐮𝐞 𝐭𝐨 𝐚 𝐜𝐨𝐦𝐩𝐚𝐧𝐲?
In my view, 𝐬𝐡𝐚𝐫𝐞 𝐛𝐮𝐲𝐛𝐚𝐜𝐤𝐬 𝐝𝐨 𝐧𝐨𝐭 𝐚𝐝𝐝 𝐯𝐚𝐥𝐮𝐞 in the longer term because share buyback as a corporate action does not impact a company’s cash flows.
I have taken an example of a firm with the following financials to substantiate my above hypotheses.
Earnings = $700.00
Shares outstanding = 1000
EPS = 0.70
Share price = $9
P/E ratio =12.85
The company decides to 𝐫𝐞𝐩𝐮𝐫𝐜𝐡𝐚𝐬𝐞 𝐬𝐡𝐚𝐫𝐞𝐬 𝐚𝐧𝐝 𝐛𝐨𝐫𝐫𝐨𝐰𝐬 𝐦𝐨𝐧𝐞𝐲 𝐭𝐨 𝐟𝐮𝐧𝐝 𝐭𝐡𝐞 𝐛𝐮𝐲𝐛𝐚𝐜𝐤.
Debt to fund buyback = $1,000
% of shares repurchased = 10%
Price/share for share repurchase = $10
Interest rate on debt = 5%
Tax saving on debt = 25%
Interest expenses due to share repurchases = $37.50
Thus after the buyback, the adjusted share count is 900, and the adj. earnings are $662.50
Thus, the revised EPS after buyback = 0.74, which is 𝟓.𝟏𝟔% 𝐡𝐢𝐠𝐡𝐞𝐫 𝐭𝐡𝐚𝐧 𝐛𝐞𝐟𝐨𝐫𝐞 𝐛𝐮𝐲𝐛𝐚𝐜𝐤.
At the P/E ratio of 12.85, the share price has to increase from $9 to $9.50 after share buyback, reflecting a price increase of 5.7%
𝐈𝐟 𝐭𝐡𝐞 𝐏/𝐄 𝐫𝐚𝐭𝐢𝐨 𝐝𝐨𝐞𝐬 𝐧𝐨𝐭 𝐜𝐡𝐚𝐧𝐠𝐞, 𝐭𝐡𝐞 𝐬𝐡𝐚𝐫𝐞 𝐩𝐫𝐢𝐜𝐞 𝐰𝐢𝐥𝐥 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐛𝐲 𝟓%. 𝐇𝐨𝐰𝐞𝐯𝐞𝐫, 𝐰𝐢𝐭𝐡 𝐚𝐧 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐢𝐧 𝐄𝐏𝐒, 𝐭𝐡𝐞 𝐝𝐞𝐛𝐭 𝐡𝐚𝐬 𝐚𝐥𝐬𝐨 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞𝐝, 𝐛𝐫𝐢𝐧𝐠𝐢𝐧𝐠 𝐝𝐨𝐰𝐧 𝐭𝐡𝐞 𝐏/𝐄 𝐫𝐚𝐭𝐢𝐨. 𝐓𝐡𝐮𝐬, 𝐭𝐡𝐞 𝐬𝐡𝐚𝐫𝐞 𝐩𝐫𝐢𝐜𝐞 𝐚𝐭 𝐭𝐡𝐞 𝐥𝐨𝐧𝐠𝐞𝐫 𝐭𝐞𝐫𝐦 𝐰𝐢𝐥𝐥 𝐧𝐨𝐭 𝐢𝐧𝐜𝐫𝐞𝐚𝐬𝐞 𝐝𝐮𝐞 𝐭𝐨 𝐭𝐡𝐢𝐬 𝐜𝐨𝐫𝐩𝐨𝐫𝐚𝐭𝐞 𝐚𝐜𝐭𝐢𝐨𝐧
However, if the company 𝐟𝐮𝐧𝐝𝐬 𝐭𝐡𝐞 𝐛𝐮𝐲𝐛𝐚𝐜𝐤 𝐭𝐡𝐫𝐨𝐮𝐠𝐡 𝐢𝐭𝐬 𝐜𝐚𝐬𝐡 𝐫𝐞𝐬𝐞𝐫𝐯𝐞𝐬, it implicitly admits that it does not have investment opportunities that exceed its cost of capital. Thus, the management returns the excess cash instead of reinvesting it in projects with lower returns.
Thus, 𝑺𝒉𝒂𝒓𝒆 𝒓𝒆𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔 𝒎𝒂𝒌𝒆 𝒔𝒆𝒏𝒔𝒆 𝒂𝒔 𝒂 𝒕𝒂𝒄𝒕𝒊𝒄 𝒇𝒐𝒓 𝒂𝒗𝒐𝒊𝒅𝒊𝒏𝒈 𝒗𝒂𝒍𝒖𝒆 𝒅𝒆𝒔𝒕𝒓𝒖𝒄𝒕𝒊𝒐𝒏, 𝒃𝒖𝒕 𝒕𝒉𝒂𝒕 𝒅𝒐𝒆𝒔 𝒏𝒐𝒕 𝒊𝒎𝒑𝒍𝒚 𝒕𝒉𝒂𝒕 𝒔𝒉𝒂𝒓𝒆 𝒓𝒆𝒑𝒖𝒓𝒄𝒉𝒂𝒔𝒆𝒔 𝒊𝒏 𝒕𝒉𝒆𝒎𝒔𝒆𝒍𝒗𝒆𝒔 𝒄𝒓𝒆𝒂𝒕𝒆 𝒗𝒂𝒍𝒖𝒆.
Some companies 𝐣𝐮𝐬𝐭𝐢𝐟𝐲 𝐬𝐡𝐚𝐫𝐞 𝐛𝐮𝐲𝐛𝐚𝐜𝐤𝐬 𝐛𝐞𝐜𝐚𝐮𝐬𝐞 𝐭𝐡𝐞𝐲 𝐟𝐞𝐞𝐥 𝐦𝐚𝐫𝐤𝐞𝐭𝐬 𝐡𝐚𝐯𝐞 𝐮𝐧𝐝𝐞𝐫𝐩𝐫𝐢𝐜𝐞𝐝 𝐭𝐡𝐞𝐢𝐫 𝐬𝐡𝐚𝐫𝐞𝐬. But, again, 𝗻𝗼 𝘃𝗮𝗹𝘂𝗲 𝗰𝗿𝗲𝗮𝘁𝗶𝗼𝗻 𝗵𝗮𝗽𝗽𝗲𝗻𝘀, 𝗯𝘂𝘁 𝘃𝗮𝗹𝘂𝗲 𝘁𝗿𝗮𝗻𝘀𝗳𝗲𝗿 𝗵𝗮𝗽𝗽𝗲𝗻𝘀 from one set of shareholders who sell the shares to those who hold them.