Capital Allocation: Repurchasing Shares; Paying out Dividends or Retaining the Moneywww.csinvesting.wordpress.comstudying/teaching/investing Page 3
rise, but for a stock buyback that is about as meaningful as saying that the investment in the East Asian market byour fictitious company,
, was a brilliant move because ultimately the common stock went up. Itconfuses cause and effect. It confuses the real success of an investment with the mirror of it in the stock market.
CALCULATING THE INVESTMENT VALUE OF REPURCHASED SHARES
A stock repurchase should be analyzed, just as any other investment would be, on the basis of the projected streamof income and cash flow over time. On that basis, there are sometimes splendid opportunities. In the late 1970s, forexample, when I
was president of
, a leading food chain, its stock wasselling at about five times its current earnings and at an even lower multiple of projected earnings for the next threeto five years. Even at five times earnings, the buyback promised a return after taxes of 20 percent a year, well
above the company’s int
ernal benchmark for investments in the business itself. Better yet, the company hadsufficient capital resources so that there were no hard choices to make. It could build and support whatever newstores were available
good sites are hard to find
and it could (and did) also buy back over 5 percent of its shares.In buying those shares, the company was capturing for the continuing shareholders a stream of income, much as it
would in a tangible investment. And unlike some of the other “opportunities” availa
ble to the company, this onewas in an already profitable business, the one that management knew best. It already knew that the accounting washonest, and the bills had all been paid on time.In the 1980s, when I
was no longer at the company
which may have been the reason
stock rose sharply. Everyone was delighted, but that is not why the earlier decision toshrink the number of shares was a good idea.It is true, of course, that shares of its own common stock w
ere not an “investment” for
in theusual sense. They could not be booked as an asset. (Once upon a time the accountants allowed such tricks, but nomore.)
the company, was poorer, not richer, for having made this
investment. (Acynic might have said that too many such successes would have undone the company.) Still, a buyback should beanalyzed as an advantageous investment, if
and it is a big if
management is looking at the long-term welfare of all the shareholders and if it can increase the intrinsic value per share outstanding after the transaction. For thecontinuing shareholders, a share repurchase is often a particularly exciting concept, with high prospects foradvantage.
BARGAIN PRICES: FAIR OR UNFAIR?
Buying back stock for 50 cents on the dollar of intrinsic value may not seem controversial, but like everything elseabout buybacks it is. One fear is that what is good for the continuing shareholders is, by definition, bad for thosewho have sold their shares back to the company. W
hy would anyone knowingly sell “dollars” for 50 cents? There
must have been some deception, or else the sellers would not have sold. In short, the critics suspect that at the heartof any bargain purchase there inevitably lies an unfair advantage.The implicit assumption is that a stock repurchase program is a zero-sum game; whatever one group gains, theother loses. And behind that assumption lies
another important one: in substance a company’s shareholders all have
the same investment goals or horizons. If
were privately owned, with only twenty or soshareholders, that second assumption would be essentially correct. None of the twenty could trade in and out of thestock. The shareholders would have little choice but to measure their personal profits
in terms of the company’s
profits and dividends. But for a public company, the assumption that all the shareholders are patient holders whohave held the stock for years and expect, or at least are willing, to leave it to their children is obviously unrealistic.Trading has soared since 1960, when a pokey 3 million shares a day changed hands on the NYSE. Now theturnover is 150 million shares of more a day (in 1990). It is not Uncle Bill in Peoria who is doing all that trading.
Compare Van Horne, Financial Management, page 380 (rejecting the treatment of a share repurchase as an investment).