Contrary to the common wisdom, buybacks don't create value by increasing earnings per share. The company has, after all, spent cash to purchase those shares, and investors will adjust their valuations to reflect the reductions in both cash and shares, thereby canceling out any earnings-per-share effect. If increasing earnings per share were the only rationale for buybacks, they would have no impact on valuewhich, as we've seen, is certainly not the case.
Buybacks affect value in two ways. First, the buyback announcement, its terms, and the way it is implemented all convey signals about the company's prospects and plans, even though few managers publicly acknowledge this. Second, when financed by a debt issue, buybacks can significantly change a company's capital structure, increasing its reliance on debt and decreasing its reliance on equity.
The signaling effect of share buybacks has been the focus of much academic research over the past ten years. According to these studies, investors and analysts use a company's financial decisions as a window into what management really thinks about the company's prospects. The announcement of a share buyback, the argument goes, indicates that managers are so confident of their company's prospects that they believe the best investment it can make is in its own shares.
If only it were that simple. In real life, investors interpret a company's decisions through the lens of past experience and in its current context, taking into account a host of other indications and signals. As Merck found out, the information conveyed by a buyback announcement is not always the information that management wants to express. In my experience, a buyback announcement can send a negative signal in these situations.
First of all, other information can contradict, and sometimes swamp the intended buyback signal. From November 1998 through October 2000, for instance, the computer giant Hewlett-Packard spent $8.2 billion to buy back 128 million of its shares. According to HP executives, the aim was to make opportunistic purchases of HP stock at attractive pricesin other words, at prices they felt undervalued the company. But if managers hoped thereby to signal good operating prospects to the market, they should have saved themselves the trouble. The buyback signal was completely drowned out by a rapid succession of other moves, all emitting contradictory and more powerful signals about the company's future: an aborted acquisition, a protracted business restructuring, slipping financial results, and a decay in the general profitability of key markets. By last January, HP's shares were trading at around half the average $64 per share paid to repurchase the stock.
Buybacks can also backfire for a company competing in a high-growth industry because they may be read as an admission that the company has few important new opportunities on which to otherwise spend its money. In such cases, long-term investors will respond to a buyback announcement by selling the company's shares. This effect is most commonly observed when, like Merck, the company is in a technology-laden business because those industries change quickly and companies competing in them need to demonstrate high growth potential. IBM, for instance, has seen no clear benefit from the $27 billion it spent on buybacks between 1995 and 2000 because the cash payout only heightened analysts' concerns over the company's ability to continue coming up with new products and services.
Finally, the credibility of a signal is seriously weakened if the company's managers choose to participate in the buyback themselves. When managers elect to sell shares rather than retain them, that suggests to the markets that the managers do not believe in their own estimates of value. They have not, in effect, put their money where their mouths are. All other things being equal, though, if managers do not participate, the benefits can be dramatic. One study of tender-offer buybacks has shown that programs in which managers did not participate generated returns seven percentage points higher than those they did join in.
|Other information can contradict and sometimes swamp the intended buyback signal.|
Buybacks can also affect value by changing a company's capital structure. Indeed, many companies use them as a way to increase their reliance on debt financing. Early last year, for instance, Payless ShoeSource increased its long-term debt from $127 million to $383 million by repurchasing 25% of its outstanding shares through a tender offer. Its debt increased from 10% of capital employed to 33%, and the returns to shareholders were remarkable. Immediately after the buyback was announced, Payless's share price rose from $40 to $52.
Leveraging has traditionally conferred two great benefits. First, interest payments on debt are, of course, tax deductible, which means that the after-tax cost of debt is well below the shareholders' expected return on equity, reducing a company's average cost of capital. A rough value of this extra tax shield can be easily calculatedmultiply the increase in debt by the current corporate tax rate. In the case of Payless, the value of the additional tax shield came to about $103 million ($384 million less $127 million times 40%). In situations involving a straight substitution of debt for equity, this value plus the enterprise's initial value before the buyback are now distributed across a smaller number of outstanding shares, dramatically increasing the value of each share.
But debt finance is appropriate only if there are any taxable profits for the interest expense to shield from taxation and if servicing the debt will not impose an unnecessary risk of financial distress. Companies can know the answers to those questions only if they can predict their future cash flows with a reasonable degree of confidence. That's difficult when a company is, like Merck, in an industry in which growth comes in rapid bursts. The market value of such a company depends on investors' assessment of its portfolio of future investment opportunities rather than on expectations about the future cash flow of current operations. In such risky situations, companies should rely on equity finance rather than debt finance.
The second benefit of debt is that it serves as a discipline for managers. Unlike equity, debt binds managers to pay out future cash flows. As many financial commentators have argued, the need to pay cash to bondholders prevents managers from investing in projects that earn returns below the company's cost of capital. This effect is most often observed in LBO situations, where the company's operating performance frequently improves dramatically after its debt levels have risen. Companies that are largely equity financed will almost inevitably forgo most of the benefits of this effect, although they can mimic some of them by adopting appropriate performance measures. 1
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The Perfect Buyback
Excerpted with permission from the Harvard Business Review, April 2001, Vol 79, No. 40.
Perhaps the most striking recent example of a well-executed buyback is the one launched by SPX, a diversified industrial manufacturer of everything from automatic fare-collection systems to tire gauges. On April 10, 1998, SPX announced a Dutch-auction tender offer for 2.7 million shares, or 18% of the total shares outstanding. The tender range was set between $48 and $56 per share, representing a 24% to 45% premium over the year's opening price of $38 3/4, and a 12% to 30% premium over April 8th's $43 close.
With its aggressive terms and size, the buyback was a clear affirmation of faith in the company, reinforced by senior management's explicit pledge not to tender their own shares. What's more, since the buyback was financed through debt, it served to radically releverage the company's balance sheet.
The market roared its approval, as SPX's share price posted an extraordinary return of 20% over the two days, following the announcement. Indeed, such was the confidence of investors in the company that SPX was unable to secure more than 80% of the number of shares it wanted to repurchase, even at the upper price limit of $56. It was forced to continue buying back shares in the open market. Within one month, the stock was trading over $70.
As a further affirmation of the benefits of buybacks, SPX has pledged to replace its quarterly cash dividend with share repurchases as the preferred method of returning cash to shareholders, pointing out that buybacks allow shareholders more flexibility in tax planning. As CFO Patrick O'Leary puts it: "We are giving shareholders a choice."
1. One study by Stern Stewart has shown that the adoption of the EVA metric for measuring performance and determining management rewards has a positive effect on value. Those companies studied that used the measure reaped returns some eight percentage points above the average. I believe that the effect of the measure is analogous to the behavioral effects of debt observed in LBO firms.