Investor Essentials Daily

Coronavirus might be the end of corporate share buybacks, shareholders shouldn’t care

April 20, 2020

Recent discussions about potential government bailouts have come with a laundry list of potential drawbacks, including the ability to ban bailed-out corporations from executing share buybacks.

Today, we’ll quickly examine the value of share buybacks.

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Coronavirus has had a widespread impact on public health, societal behavior, and the global economy.

While most nations remain on some level of lockdown or quarantine, the restaurant industry has shriveled, global travel has fallen to multi-decade lows, and people are spending more time than ever at home.

We’ll begin seeing the real financial impact as companies start reporting earnings over the next two quarters, but we can already tell this has the potential to be future-altering for many industries.

The travel industry, spanning from airlines to plane manufacturers and ride-sharing apps, is expected to have their worst results in decades, in some cases.

Some companies like Boeing (BA) have been working with legislators and high-ups in the U.S. government to bring as much as $60 billion in aid to the aerospace industry in the form of guaranteed loans and bailouts.

Given that we’re only a decade removed from the largest corporate bailout in history when the U.S. provided our banking system with $700 billion, talks of another bailout of similar scale have been met with some level of opposition.

Some lawmakers, including Senator Elizabeth Warren, are calling for strict regulation to any proposed bailouts. One of these requests is to permanently ban any corporation which receives bailout money from executing a share repurchase program ever again.

The likelihood of this provision being adopted remains small, but it calls into question why Senator Warren would specifically attack share buybacks as opposed to, say, dividends.

It’s fair to say that, compared to dividends, share buyback programs are more of an algebraic exercise than a tool to return real value to shareholders.

The two traditional arguments for share buybacks are that they can help boost EPS and they give the company a chance to buy shares when it thinks they are undervalued.

We can address each of these in quick succession.

First, any boost in EPS driven by share buybacks is purely mathematical, and it’s not tied to actual value creation.

Earnings (or in our case Uniform earnings) can increase to grow EPS or shares outstanding can decrease.

In the latter scenario, the company’s actual value creation doesn’t change, only the number of shares in the market.

Because of this, many companies have started ignoring the impact of share buybacks when calculating EPS for management’s compensation metrics—they have recognized that buying back shares does not actually create value for the company.

Literally, when they give EPS compensation, they exclude the benefit of buying back shares.

The second argument is that share buybacks allow the company to benefit from stock price appreciation when it thinks its shares are undervalued.

While that’s valid in theory, in practice, the impact is negligible. The best way to demonstrate this is through a thought experiment.

In this case, Company A realizes that its shares are undervalued on the market by 30%—a significant amount. Because of how undervalued its shares are, the firm decides to repurchase 10% of its outstanding shares.

Based on the simple math, the most value the company can expect to receive is 3% of the firm’s value—and that’s assuming that the stock price doesn’t rise due to a massive spike in demand.

In reality, the firm can expect to receive less than 3% total return from what would be among the historically large buyback programs in history.

So, considering the value share buybacks create for anyone in reality, versus how much management teams prioritize this drain on cash flow, no wonder Senator Warren and others want them deprioritized.

While we think the likelihood of a permanent buyback ban is slim to none, considering how value-neutral share buybacks tend to be, it may not make a huge difference to investors either way.

All the best, as always,

Joel Litman & Rob Spivey

Chief Investment Strategist &
Director of Research
at Valens Research

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