When I wrote this, I simply dismissed the idea of any merit in the standard arguments for how stock repurchases help the shareholder. Much later, I got around to looking closely enough at those arguments to see how transparently silly they are, and even wrote up what I found.

The New Dividend

A company we know and love has announced its intention to flush another 80-90 million dollars into the stock market by means of a stock repurchase. Contemplating that (or actually, finding that the announcement reminded me of earlier musings), I have come to some conclusions so completely obvious that it's almost surprising that no one else seems to see them.

The stock repurchase plan is, of course, fundamentally a way of distributing the corporation's excess profits. PR people can blather on and on about how it increases earnings per share by retiring shares, but so what? Absent a sophisticated analysis of elasticity of supply and of demand, this is just a pretense that pushing up the price and raising the EPS are two effects instead of one. So what is special about this way of distributing earnings?

Benjamin Graham, the father of modern security analysis, said some sharp things about stock repurchase, but he was an old fuddy-duddy who lived through the Depression. Besides, he was talking about the rights of shareholders, whereas these days the shareholders want buybacks. Or, as I'll show, some of them do and the others have no voice.

The old-fashioned dividend directly rewards people who own your stock. And the dividend has a secondary effect of supporting a higher stock price, so long as the market places a value on dividends. However, dividends are way out of fashion for some reason. (Double taxation? No; money distributed through stock purchase is taxed the same way, as long as there's no major capital gains tax break.)

The stock repurchase, in contrast, acts or fails to act on three levels:

Does this suggest anything? It does to me: I think it's part of the same economic madness as the mania for quarterly earnings at all costs. If it doesn't strike you that way, though, I won't insist on the point. All that matters is that the people who control the money and set the rules have made the rules clear, and ignoring that kind of information is a good way to lose money.

So: what do you, as a private shareholder, conclude from the fact that growth companies want you either to be a fund manager or to sell their stock? I mean, given that you aren't a fund manager and don't want to be, what can you do but sell?

Repurchases: The Stockholder's Friend:

Whenever a board of directors announces a stock repurchase plan, the press release lists the benefits of the repurchase to you and me, the ordinary stockholder. The benefits invariably come from this short list, though they may not all be mentioned in a single news story. I'll consider these one by one. Show me a coherent rebuttal to any of these, and I'll insert a pointer to the Web page where you display it--and/or modify my argument and give you due credit.

The pool of available stock

This benefit is often hinted at, but not so often stated outright. The reason it tends to be hedged about seems to be that even a financial reporter is likely to understand that it's false.

In the blatant presentation of this argument, the company is handing out lots of stock options to get better performance from the executives (a subject on which there is much to be said, but not here and now), and when the options are exercised, the pool of shares held for the purpose starts to get low, so the company replenishes the supply by buying in the open market. The trouble with this argument is that there is no such pool.

There used to be something called treasury-stock accounting, in which the company could own some of its own stock as an asset. Don't ask me just how it worked, because it hasn't been used in many years. (My authority: members of a top accounting firm, working on contract to a publicly traded company, advising directors of that company. If you know better, let me know.) In real life, when an American company buys back its shares, they simply cease to exist. If it then issues new shares, they are in every sense new shares, not a reincarnation of the old ones.

(You can easily confirm this for yourself. When a company spends money, that's a Credit transaction; by the immutable laws of double-entry bookkeeping, without which Western Civilization would collapse instantly, there must be a balancing Debit. Thus, when it buys equipment, the spending of money (Credit) is balanced by a new asset (Debit) called Plant and Equipment. So look in the balance sheet. Where do you see an asset item for that stock they bought back? Nowhere; the Debit entry is a reduction in the company's capital (which for good technical reasons is treated as a liability).)

It is possible to run through the number of shares authorized for the option plan. When you do, you go to the stockholders for a new option plan authorization; buying back shares has no effect whatsoever.

It's also possible to hit the limit on outstanding shares that's written into the articles of incorporation. In this case, buying back shares really will make a difference. But why spend tens of millions of dollars on purchases instead of tens of thousands on amending the articles and getting shareholder approval at the next annual meeting? This is a question you really ought to ask of management. Let's hope their reason is not that they're not sure the stockholders would vote the authorization.

Also, if they can't track something as simple as the number of shares outstanding, you don't even want to think about what they're doing with the cash flow.

The anti-dilutive effect

It's a fact that when a company issues new shares, the existing shareholders have a smaller piece of the company than before. Of course, if the shares are sold at a proper price, the sale increases the total value of the company by exactly enough to balance the reduction of your percentage. And Santa Claus is your uncle--the growth companies that commonly do repurchases aren't valued on the amount of cash they have in the bank.

Anyway, the company is selling huge amounts of stock at even less than market value to the executives who have options; that's their big incentive to make the company do better. (Space is provided here for sarcastic remarks about work ethic and wanting to do a good job for its own sake.) And that does dilute your percentage ownership of the company. So, the argument goes, the company buys stock back to counterbalance that change.

Sometimes the financial press looks like a huge Marxist conspiracy to make us forget about the Free Market. I mean, the great institutional investors buy and sell the stock freely, and they pay analysts to know all about the company and its stock. The analysts know the company's policy on stock options; the company is happy to tell them. The analysts know how many options are outstanding right now; it's in the financial statements. The analysts know the prices of those options; they're in the financial statements. The analysts know when the options can be exercised; it's in the financial statements. So, have they been advising their clients to price the stock in consideration of its known future dilution, or haven't they?

Let's make this perfectly clear. You buy a growth stock with the idea of selling it later for more than you paid for it today. Today's purchase price is based on the company's current operations and policies, and the way they're expected to work out in the future. The future selling price will be based on how things did work out, in combination with the company's then-current policies and how they are then expected to work out. Dilution caused by the issuance of options won't affect the growth of the stock as long as the policy doesn't change. The company hopes. of course, that the options policy will help the company's growth, but that has nothing to do with the buyback policy.

The company may decide to buy back shares because of dilution by options. It may decide to buy back shares because it feels rich today. It may decide to buy back shares because the moon is in Pisces. The money doesn't care why it's going into the stock market, nor do the shares care why they're coming out. All that matters is whether the purchase of the shares is a good investment to make. That's the subject of the next section.

Raising Earnings Per Share

If you divide the company's annual profits by the number of shares outstanding, you get the earnings per share, or EPS. This is your piece of the company's profits if you own one share, and it's considered a pretty good measure of the value of a company's stock; there's even some economic theory behind it.

Obviously, the company can raise the EPS by getting more earnings or by supporting fewer shares. The big, big argument for Shareholder Value in a stock buyback is that it raises the EPS for all the remaining stockholders. Buy back 1% of the shares, and the EPS goes up 1% (Yeah, really 1.010101...%, but so what?), and the price should follow. A nice benefit to the shareholders, at no cost to them.

What, no cost? Well, hardly any: perhaps we should remember that it's the stockholders' money that the company is spending to do this. But as I mentioned above, the cash in the bank isn't a major measure of the value in many cases, so we just glide past this detail.

But is this, in fact, a good investment for the company's money? To the superficial observer, it sounds a whole lot like the whiffle bird, which flies backwards in ever-decreasing circles until it disappears up its own anal extremities. But that's not a serious economic analysis. Here is a serious economic analysis.

Since algebraic formulas put most people off, and this is really a very simple matter (and anyway HTML can't handle formulas decently), we'll illustrate by working out a case with specific numbers. Our hypothetical corporation, then, has $100,000,000 in annual profits and 50,000,000 shares outstanding. Let's say it's selling for $40 a share. Then the EPS is $100,000,000/50,000,000 or $2.00, and the price is 20 times earnings ($40/$2). These are reasonable numbers at the time of writing: look up the PE for Microsoft or Sun or CompUSA; or Autodesk, which is seriously depressed at the moment but is still at close to 20 times earnings. And let our Hype Corp. be cash-rich, with $125,000,000 in the bank.

Now it buys back 1% of its stock. That's 500,000 shares at $40 a share, or $20,000,000. It can afford that much. The profit is now spread over only 49,500,000 shares, giving EPS of $2.02 (plus a negligible amount). Sure enough, we've raised EPS by 1%.

Now, instead of buying back shares, suppose we to use that $20,000,000 to buy a bond paying 5%. Let's see, carry the 1, yeah, that's $1,000,000 a year in interest, for a total of $101,000,000 profits, divided by the original 50,000,000 shares: $2.02 a share. We've increased EPS by 1% again.

So if Hype Corp. can find any way of investing the company's money (Your money) at better than 5% after tax, it should do that. If it buys back the stock instead, the treasurer -- no, the board of directors, who give the orders -- should be fired for wasting your money, and possibly sued for breach of fiduciary duty. If they can't find any way of getting 5% on the money, just what the Hell are they doing managing the money for a public corporation?

(Just now, 30-year U. S. Treasury bonds yield about 7%. After taxes, that will come to a little less than 5%. This is one really boring investment, on which you'll never lose your principal or your interest, though the market value will go up and down some. Shouldn't your favorite growth company be able to beat that by finding an investment that has some small risk and a commensurate return?)

It really is this simple: divide the price-earnings ratio into 100, and see if you can invest at a higher percent return than that, taking into account the amount of risk involved. If not, buy back the shares.

"You've just proved nobody should invest in growth stocks...

but just put everything into government bonds. Where would we be if we all took that advice?"

Well, there are people who don't believe in buying stocks at a high multiple of earnings, but I don't have to defend that theory here. There are plenty of reasons to buy expensive growth stocks, and if the company wants to speculate in its own stock, by all means let it do so.

But don't let it tell you it's raising the EPS that way. The point of my argument is that even lousy, stodgy, low-profit government bonds are competitive with buybacks as an EPS-raiser.

And who says the company needs to invest in stocks and bonds? Maybe the worst thing the company does to you when it invests in its own shares is to tempt you to think that investment is something you do on Wall Street. Wrong. What happens on Wall Street is a pale reflection of real investment, which buys buildings and machines and software. That's what your company is not doing when it buys back its shares.

"Das kannt jeder Esel"

After the premier of Brahms's First Symphony, some musically gifted person pointed out that the fourth movement contained a direct quote from Beethoven's Ninth. Brahms replied as above: Any ass knows that!

And this is a valid response to my little essay on investment returns:
What? You spent all that time showing that the investment return is the reciprocal of the PE ratio? Big deal!

Yeah, I agree. So tell me, why is the raising-EPS argument parroted continually in the press, along with the other two I've mentioned, with never a whisper that the price at which you buy back could make a difference? Is it that we need more asses in the financial press?

A Real-World Case of Repurchase

Here is an example of buybacks by a successful publicly traded company and market-share leader. It is by no means the silliest example in these pages, much less the nearest to fraud on the stockholders. My thanks to John Walker for compiling the data, up to and including the average price; the last items are my calculation, for which he bears no responsibility. The numbers are, of course, adjusted for splits.

                       Autodesk Stock Repurchases                          
    Fiscal Year            Shares     Avg Price          Total              
        1992              420,000       15.81           6,640,200           
        1993            2,404,000       17.95          43,151,800           
        1994            3,176,000       22.54          71,587,040           
        1995            2,990,000       20.05          59,949,500           
        1996            2,761,000       40.43         111,627,230           
        Total:         11,751,000                     292,955,770           
Average price of all repurchases:       24.93                               

Price of the stock, August 29, 1996:    23.125 (up 1.125 from 8/28)
We can calculate the rate of return on this investment. To simplify, we assume that purchases were done at the end of each fiscal year. Also, we take into account the cash saving produced by not having to pay dividends on the repurchased stock; being too lazy to look up the data, we also assume that the dividend rate has always been its present $0.24 a share, which is too high and makes the investment return look better than it is.

The figure I get is minus 2% a year.

The Real World Strikes again

On September 3 or 4 I was about to add something to this effect:

And if you calculate the effect that repurchasing the stock will have on the price, as by multiplying the increase in EPS by the current price-earnings ratio, you can expect that the real effect will be significantly less. After all, the continued growth in the stock price depends on the continuation of the repurchase policy; and the market must discount the risk that the policy will come to an end sometime, pulling out the support from the price. For example, Rubbermaid may run out of money to continue the buybacks.

But I was too lazy to work this into the text. So on September 5 the Wall Street Journal reported that Rubbermaid's stock dropped when it announced a major acquisition (Graco) and surprisingly bad estimated third-quarter earnings. No big deal until you read a few paragraphs into the story:

...Wall Street also reacted to the fact that Rubbermaid's use of short-term debt to buy Graco would temporarily halt the company's continuing share-repurchase program, noted Scott Graham of Oppenheimer & Co.
All I can add to that is, "Whaddaya mean, temporarily?" In all fairness, maybe this weakens my argument that the analysts pay attention to what the company is doing, and advise their clients on how that should affect the price of the stock.
Date last modified: November 11, 2000
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Copyright (C) 1997 Daniel Drake. A royalty-free license to reproduce this document in whole or in part is hereby granted provided (i) all additions, omissions, and other changes are clearly marked; (ii) the work is not reproduced as, or as part of, a work for which payment is charged; (iii) this notice is reproduced without change. Quotations for critical or polemical purposes, with proper attribution, are permitted in any case, being obviously fair use.