Share buybacks are becoming more and more popular as a way to return cash to shareholders. Personally, they are one of my favorite things to see a company doing as they show capital budget discipline and long-term faith in the existing business from management and the board of directors.
Historically, share repurchases have been associated with outsized returns as mentioned in a Harvard research paper that outlines long-run abnormal returns in the order of 30 percent over three to four years for U.S. companies and 25% over three to four years for global companies in 32 different countries.
This article will go over what investors need to know about share buybacks from their tax efficient status to their effect on equity, EPS, and financial leverage metrics.
Tax Efficient Shareholder Returns
Share buybacks are a tax efficient way to return capital to shareholders for a couple of reasons; the delayed timing when taxes are paid and the favourable tax rate being applied. While both dividends and share repurchases are made with after-tax net income from the corporation, dividend income is taxable in the investor’s hands in the year in which the dividend was paid. On the other hand, share repurchases are not taxable in the investor’s hands until the shares are sold in the future. Due to the future timing of tax being paid, returns to shareholders in the form of buybacks can continue to grow tax free in the meantime.
At this future date of sale, the distribution to shareholders is now effectively taxed as capital gains with each share now representing a higher percentage of the value of the company. In terms of tax rates, countries often tax capital gains at favourable rates compared to dividend income so not only is the tax burden delayed in the future, but it is also now taxed at a lower capital gains tax rate. This tax efficient reason is probably one of the reasons why share repurchases have become such a popular way to return cash to shareholders.
Share Repurchases Can Boost EPS
Another effect of a company repurchasing shares is that depending on the source of cash used to repurchase the shares (ie. free cash flow or debt), the result can be a boost to earnings per share (EPS). This is why even stagnant growth companies with flat net income can still achieve EPS growth when repurchasing shares. All else being equal, if a company repurchases 5% of their shares during the year with excess free cash flows, EPS will be higher by 5% even if the net income of the business is flat because there are 5% fewer shareholders to share the profits with.
On a negative note, this boost in EPS can also obscure a declining business that is becoming increasingly risky. This is the case for investors if the share repurchases are being paid for with debt instead of excess free cash flows. Because debt is normally a cheaper source of financing, issuing debt to repurchase shares can have a positive effect on EPS. This EPS growth effect is not sustainable and would need to be backed out when analysing the company’s growth rate. Debt levels and leverage ratios should be watched closely to ensure any share repurchases are being sustainably financed with free cash flows and are not changing the company’s capital structure and risk profile.
If earnings yield is GREATER than after-tax cost of debt, then buybacks are ACCRETIVE to EPS
If earnings yield is LESS THAN after-tax cost of debt, buybacks are DILUTIVE to EPS
For example, say a company is able to raise debt on an after-tax basis at a cheaper rate, say 5%, than the earnings yield (inverse of P/E ratio), say 8%, given the price their shares are trading in the market. Let’s say this fictional company had $100M of net income and 25 million shares outstanding which currently trade in the market at $50.0 per share. By repurchasing $100M of shares by issuing debt in this scenario, the business will be able to artificially boost EPS by $0.13 (a 3.3% increase) by issuing cheaper debt in order to invest the proceeds in their higher yielding shares.
Effect of Share Buybacks on Equity and Book Value
As share repurchases alter the amount of equity in the business, they can alter book value (BV) and create a misleading effect on financial statements, financial leverage metrics, and valuation metrics such as price to BV.
This is because if a company’s shares are trading at a price above BV per share in the market, then repurchasing that share will result in more equity coming off the balance sheet than the proportional amount of BV that share represented.
This transaction will therefore cause BV per share to decrease. The opposite is true if the price at which the share is repurchased is a bargain purchase made at less than BV per share as such a purchase will result in higher BV per share.
If share price is GREATER than book value per share, then buybacks are DILUTIVE to book value per share
If share price is LESS THAN book value per share, buybacks are ACCRETIVE to book value per share
Example with Coke
For example, let’s look at Coke and imagine that the company repurchasing shares in the market at $50 per share. Coke had an average of 4,299 million shares outstanding for 2018, and total equity value on the balance sheet of $19,058M as of December 31, 2018. What would be the effect on BV per share if $1,000M worth of share buybacks are made at the current $50 market price? As can be seen below, as the share repurchases were made at market prices above BV per share, the BV of Coke will decrease by $0.25 per share to $4.18.
This decrease in equity not only can have an effect on BV per share but can also skew leverage ratios. Let’s keep looking at Coke, who over the past decrease has seen financial leverage (which is assets divided by equity) increase around 94% from 2.4x in 2010 to 4.6x in 2019. This large increase in leverage is out of whack with the fact that total liabilities at the company have only increased around 35% to now be $77.5B in 2019. This outsized increase in financial leverage is not so much due to rising liabilities of the company but has also been influence a good deal by the declining equity invested in the business due to continuous share repurchases.
With enough share repurchases to pay back the equity capital the business’s shareholders have both invested and earned, equity on the financial statements will eventually turn negative as can be seen on Autozone’s balance sheet. Normally, an equity deficit in the business would be viewed negatively as if the business has been losing money for shareholders.
However, with large share repurchases being made sustainably, such an equity deficit is actually a sign of a highly profitable business that has been able to return all the equity invested and earned back to shareholders. Coke has not reached that negative equity point yet, but at the current rate of the company only looks to be another decade away from such a feat.
Good for the Economy?
In the news, readers have probably seen stories about how corporate share buybacks are bad for the economy because businesses aren’t investing in the economy.
On the opposite side, and in a cold calculated capitalist opinion, a company buying back shares in the market is returning cash to the economy through giving it back to investors who were once holding the shares that were repurchased and saying “hey, we have no great growth opportunities for this cash and you would probably be able to better deploy it elsewhere”.
So if you ever get the “bad for the economy” comment while telling your friends how much you like a company making sustainable share buybacks, feel free to engage them in that lively debate.