LEGG MASON

CAPITAL MANAGEMENT

January 10, 2006
Michael J. Mauboussin

Clear Thinking about Share Repurchase
Capital Allocation, Dividends, and Share Repurchase
Why Buybacks are so Important Now
When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace, no alternative action can benefit shareholders as surely as repurchases. Warren Buffett BerkshireHathaway 1984 Annual Report

mmauboussin@lmfunds.com

7.0% 6.0% 5.0% 4.0% 3.0% 2.0% 1.0% 0.0% 2005E 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

Dividend Yield
Source: Empirical Research Partners.

Buyback Yield

Total Yield

• •

Corporate America is flush, and returns and cash flows remain strong. Capital deployment is front and center. Aggregate share buybacks are now larger than dividends. While buybacks and dividends are mathematical equivalents, executives and investors conceptualize them very differently. Managers cite multiple motivations for buying back stock. A number of these motivations risk conflicting with principles of value creation. Earnings-per-share accretion or dilution has nothing to do with whether a buyback makes economic sense. The relationship between price and expected value dictates a stock buyback’s economic merits.

• •

Introduction
Corporate America is in an unusual position today: even after returning a record one-half trillion dollars to shareholders in 2005, companies remain flush. Cash balances are high, debt levels are low, and free cash flow has never been stronger. Delivering superior shareholder returns in upcoming years may require companies to show the same savviness in capital markets as they do in product markets. How did we get to this situation? The events of this century’s first six years encouraged companies to focus internally, leading to today’s financial position. These include a brutal threeyear bear market in equities (2000-2002), a number of high-profile corporate scandals, terrorism, a tight U.S. presidential election, heightened perceived geopolitical risk, a recession, and increased regulation. Companies responded by honing their operations, limiting capital spending, hiring sparingly, and hoarding capital. A recent report noted that companies in major economies went from using over $500 billion in capital to fund their operations in 2000 to generating close to $600 billion in free cash flow in 2004, nearly a $1.1 trillion swing in just four years. 1 The statistics today are impressive. Returns on capital, by any measure, are at or near all-time peaks. (See Exhibit 1.) Industrial companies in the S&P 500 sat on a cash pile of over $600 billion as of late 2005. Free cash flow margins (free cash flow divided by sales) are close to all-time highs, capital spending as a percentage of gross cash flow remains near fifty-year lows, and total debt as a percentage of assets pushes at a record low. This all occurs against a backdrop of sharp productivity gains and stable and solid economic growth. 2 While investors may fret about the fiscal health of the government or the consumer, companies are in great shape. Exhibit 1: Return on Equity for the S&P 500 (1946-2005E)

20 15

Percent

10 5 1946 1950 1954 1958 1962 1966 1970 1974 1978 1982 1986 1990 1994 1998 2002

Year

Source: Corporate reports, Empirical Research Partners, LMCM estimates.

As a specific example, take the seventy-eight technology companies in the S&P 500. Barron’s recently calculated that these companies held $140 billion in net cash, about 7 percent of their aggregate market capitalization. 3 Adopting a 20 percent debt-to-total capital ratio would allow these companies to spend almost $450 billion on some combination of capital investments, acquisitions, dividends, and buybacks. Appendix A argues corporate America’s strong financial position may continue for some time. So what will American companies do with this excess cash? Simplistically, companies have two alternatives for deploying capital: invest via capital spending, working capital, mergers and acquisitions or return capital to the business owners through dividends and share buybacks. (See Exhibit 2.) While capital deployment is ultimately senior management’s most important task, many companies and investors fail to think clearly about how to best allocate capital systematically over the long term. 4

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Legg Mason Capital Management

Ironically. Any comparisons between the ratio of dividends to buybacks before and after 1982 appear misleading. Companies have consistently returned more capital to shareholders via share buybacks than dividends in recent years. the investment opportunity management should be most capable of valuing properly. as agents for the owners rather than large shareholders themselves. shareholders do not have the same constraint.Exhibit 2: Capital Allocation Alternatives Capital expenditures Business Working capital Mergers/acquisitions Capital allocation alternatives Dividends Return cash to claimholders Source: LMCM. 5 Management’s inclination is almost always to plow capital back into the business. growth points to some important psychological factors behind dividends. Exhibit 3 shows the data for buybacks and dividends for the past 30 years or so. This stable. In reality. the data reveal a few important points: • Buybacks took off in the mid-1980s. Congress enacted rule 10b-18. often earning a higher return than the company can. or a legal shield from the threat of being sued. albeit modest. Dividends. continue to grow. the total dividends companies pay are still increasing. the company’s stock. Legg Mason Capital Management • • Page 3 . Share buybacks Debt repayment Importantly. while losing relative importance. which provided companies with a safe harbor. In 1982. Exhibit 2 implies that corporate managers must judge the best and highest use for capital through constant evaluation of the tradeoffs between investing in the business and returning cash to the owners. the buyback numbers are heavily skewed: a small percentage of the companies represent a meaningful percentage of the total. various sources provide differing sums. Notwithstanding this qualification. very few executives and corporate boards consider returning capital to the owners part of doing business. The value of buybacks exceeded dividends for the first time in the late 1990s. This rule made large-scale buybacks viable for the first time in modern history. for the first time. Indeed. While management’s opportunity set is practically limited to the company’s business or industry. That buybacks exceed dividends calls into question simple measures like dividend yield. While the propensity to return cash has shifted toward buybacks. Notably. is often dismissed in favor of harder-to-assess external investment opportunities. Since no unified approach to collecting these data exists. Dividends and Buybacks: Two Ways to Return Cash to Shareholders Companies choosing to return cash to shareholders can either pay a cash dividend or repurchase shares. This implicit bias fails to consider the crucial point that shareholders can reinvest the cash they receive into other companies or projects. managements often have an incentive to expand the business versus giving cash back to shareholders.

338.5% 4.144 100.3% 4.5% 4.343.421 51. In May 2003.375 78.6% 3.9% 2.186 137.794 144.499 114.777.018 4.8% 6.939.037 6.986. Empirical Research Partners.778 179.050 50.844 108.869 11.4% 2. similar timing.1% 5. creating a yield similar to a dividend. in part.561 163.503 1.097 66.451 2.7% 5.299 160.656.6% 4.3% 4.000 13.000 Buybacks 2.063 50.064. Researchers attribute the rise in dividends to the general maturation of companies (more mature companies are more likely to pay dividends) and a desire to provide capital markets with a signal of confidence.821 184. lowered the maximum tax rate of dividends from 38 percent to 15 percent.042. This equivalence obscures a benefit of buybacks: investors who elect to sell a portion of their holdings.890 939.610 3.842 107.050 102.1% 3.378 166. Naturally.519 91.098 6.531 8. FactSet.5% 2.5% 2.283 5.611 136.697 119.113.283. the laboratory conditions we impose on the model differ from the real world. 6 Exhibit 3: Dividend and Share Repurchase History (1977-2005E) Year 1977 1978 1979 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005E Dividends 34.2% 3.279.984 1.3% 2.961.6% Dividends as a Buybacks as a % % of total payout of total payout 95% 91% 90% 91% 89% 90% 87% 86% 72% 63% 64% 60% 63% 65% 73% 75% 73% 70% 62% 58% 51% 44% 45% 45% 48% 48% 51% 47% 47% 5% 9% 10% 9% 11% 10% 13% 14% 28% 37% 36% 40% 37% 35% 27% 25% 27% 30% 38% 42% 49% 56% 55% 55% 52% 52% 49% 53% 53% In $ millions.284 105.170 1.1% 3.214. While dividends and buybacks both return cash to shareholders.066. Source: Corporate reports.652 3.• Reappearing dividends? In the early part of the 21st century.733. no transaction costs.779.8% 3.313.675 56.318 30.224 Yield 4. Appendix B shows this equivalence in detail.206. evidence suggests that buybacks are a more efficient means of returning cash to shareholders for the following reasons: • Tax differential.563 176.087 77.862 15.552.0% 2.451 1.049 4.606 63.551 45.321 163.9% 3.861 40. comparable reinvestment rates. President George Bush signed legislation that.650 15. LMCM estimates.825 5.688 2.291.262 175.498 41.9% 5.6% 5.000 10.140 146.034.000 13.157 10. Bernstein Research.417.2% 2.051 70. a more fundamental question looms: are dividends and share buybacks mathematically equivalent? While few executives or investors consider them the same (for reasons we will explore) the methods are identical assuming the same tax treatment.122 36.868 40.636 56. Leaving aside the power of signals for a moment.288 202.516 2.932 61.223 1.507 125.494 3.100 13.6% 3.000 13.413 48. dividends gained relative ground versus buybacks for the first time in recent memory.167.906 4. and an efficient market.693 180.646.1% 4.512 81.690 194.190 220. While the permanence of this tax rate is still unclear. only pay taxes on Legg Mason Capital Management Page 4 .241.7% 4.2% 2.866 7.880 1.990 67.308 5.448.546 13.717 250.1% 5.000 Market Cap 894.189 9. taxes on dividends and capital gains are equivalent for now.077 129.619 1.355.759 108.494 223.

“no better investment opportunities are available. • The Golden Rule of Share Buybacks We can define a principle to serve as a universal yardstick for judging the rationale and attractiveness of a buyback program: 8 A company should repurchase its shares only when its stock is trading below its expected value and when no better investment opportunities are available. 7 We find a substantial gap between the theory and practice in how companies return capital to shareholders. Shareholders can choose to retain rather than sell their stock and hence defer tax payments until they sell. while having significant aversion to dividend cuts. All shareholders receive the dividend and must deal with redeployment and tax consequences. If price is truly below value. In contrast. In this case. Buybacks may appear attractive. surveys of executives suggest taxes are a second-order concern in setting payout policy. a share repurchase gives more discretion to the shareholders. executives deem buybacks much more flexible than dividends. they perceive the buyback as a residual that follows investment and dividend commitments. • Time is on your side. the shareholder who decides not to sell ends up with a higher percentage stake in a more valuable company.the difference between the selling price and their cost. For example. First. the discretion lies with the firm. assume a shareholder believes a stock they own is undervalued (a likely condition). In contrast. Objective. Value-maximizing companies fund the highest return opportunities first. A dividend affects all shareholders the same way. a buyback transfers wealth from selling shareholders to continuing shareholders. continuing shareholders earn a return in excess of the Page 5 Legg Mason Capital Management . positioning them well to make this value-versus-price judgment.” addresses a company’s priorities. The principle’s second part. Shareholder discretion? With a dividend. In contrast. The principle also has a couple of noteworthy corollaries. If a company buys back undervalued shares. even though corporate finance relies heavily on the role of taxes in judging the relative virtue of dividends versus buybacks. the timing of their cash needs. but reinvesting in the business may provide a better opportunity. the full amount of a dividend is taxable. The resulting increase in expected value per share holds with management’s objective to maximize shareholder value for its continuing shareholders. provided the stock proves to be undervalued. the benefit equals the time value of money. cost basis. Finally. and their company valuation. the rate of return on a buyback depends on how deeply the market undervalues the stock. Similarly. reinforcing the sense that dividends are a quasi-contract while buybacks are more discretionary. Deferral provides buybacks with another tax advantage. Despite this theoretical equivalence. But if the company buys back stock. analytical managers likely understand the business and its prospects better than outsiders. Executives generally consider maintaining the dividend to be on par with investment decisions. corporate executives think about dividends and buybacks very differently. Shareholders can opt in or out based on their tax situation. The first part of this principle—“a company should repurchase its shares only when its stock is trading below its expected value”—suggests management should act as a good investor by buying the stock when the price is below the value.

we can take a look at the popular motivations for buying back stock. The Motivations for Share Buybacks Since 2000.0% 8.3% 9. Dividing 8 percent by 80 percent yields a 10 percent expected return for continuing shareholders.cost of equity. As we will see. 1.2% Second.5% 8.0% 1. offsetting dilution from option programs.3% 15. Specifically we seek to distinguish between decisions that benefit continuing shareholders and those that potentially harm shareholders. managers have historically done a poor job of following through on buyback announcements.7% 13. this method offers the greatest degree of Legg Mason Capital Management Page 6 .0% 11.3% Price-to-value ratio 0. Although openmarket purchases have legal restrictions. a buyback of undervalued shares serves to increase the per-share value of the remaining shares. In this method. a buyback can be more attractive than an investment in the business.00 8. 10 Managers in general are not as committed to executing buyback programs as they are to paying dividends. The shareholder rate of return is the cost of equity divided by the ratio of stock price to expected value.0% 16. companies failed to complete 25 percent of authorized open-market buyback programs within three years of announcement. very few managers think this way. To Signal to the Market the Shares are Undervalued Though managers most often cite signaling as their primary motivation. 7% 8% 9% 10% 11% 0. Another reason the signal has weakened over the past 20 years relates to the methods companies use to buy back their shares: • Open-market purchases. Why? First.0% 10. For instance. management motivations are often far from pure and are flatly misguided in numerous instances. (See Exhibit 4. Exhibit 4: Rate of Return on a Stock Buyback Cost of equity Source: LMCM analysis. We now look at the four primary reasons companies cite for buying back their stock: signaling the shares are undervalued.8% 6.80 1. over three-quarters of the companies in the S&P 500 have bought back stock. In the 1980s. But what if a company has no excess cash or borrowing capacity and hence must partially or wholly forgo a value-creating investment in the business to repurchase shares? A company should consider the buyback when it provides a more attractive return than investing in the business. although they have improved in recent years. the most widely used by far.20 5. Armed with a means for assessing management’s share-buyback decision.8% 7. In reality.0% 12.) Managers can compare this rate of return with alternative uses of capital. Properly-oriented managers recognize they should fund all investments that promise to create value.7% 18.5% 10. for example. managing earnings per share. companies simply purchase their own shares in the open market like any other investor. say a company has an 8 percent cost of equity and the stock is trading at 80 percent of expected value. Appendix C walks through this analysis in detail. 9 the signal from buybacks has weakened over the years.8% 11.60 11. and increasing financial leverage.7% 7. Alternatively.0% 13.3% 9.

and companies generally tender for a sizable percentage of the shares outstanding. and management can execute them relatively efficiently. the company enters into a forward contract with the investment bank. allowing the company to retire a large block of shares immediately. Here. 12 Fixed-price tender offers. 11 Shareholders may tender their shares at any price within the range. the company strikes a deal with a single shareholder. particularly when made solely to offset dilution from options. On the other hand. Simultaneously. the company pays the investment bank—or gets credited—the difference between the initial and average share buyback price. Open-market purchases emit the weakest signal. The bank pays the company the time value of the funds. Consequently. especially debt-financed ones. • • In recent years we have also seen an increase in accelerated share repurchase programs. the company sums the cumulative number of shares necessary to satisfy the program. Sara Lee. open-market purchases convey the weakest signal of management conviction. At the end of the period. an expiration date. such greenmail transactions represent less than 10 percent of privately negotiated buybacks in the past 20 years. a company purchases shares from an investment bank. the number of strong-signal announcements has fallen sharply. whereas Dutch auctions and fixed-price tenders tend to convey much stronger signals. agreeing to pay the average market price of the shares the bank repurchases over a specified period. In a Dutch auction.) Page 7 Legg Mason Capital Management . typically six to nine months. and Duke Energy. some companies purchased positions from investors or companies threatening a takeover. This type of buyback remains relatively rare.flexibility. less dividends. All tendering shareholders at or below the clearing price receive the clearing price for their stock. they constituted only 4 percent of the total. however. The price is often a significant premium to the market. management offers to repurchase a set number of shares at a fixed price through an expiration date. In the 1980s. Shareholders may or may not elect to tender their shares. In the 1980s. Dutch auctions and fixed-price tenders represented about 22 percent of buyback volume in the U. Starting at the bottom of the range. With this method. management defines the number of shares it intends to buy. Dutch auctions generally send strong signals. • Dutch auction. (See Exhibit 5. tend to be powerful. HewlettPackard. However. In this case. there is net settlement between the parties. Companies utilizing accelerated share repurchase programs in 2005 include DuPont. In the 1990s. and a price range within which it is willing to buy (generally a premium to the market). Fixed-price tenders. positive signals to the market.S. Privately negotiated purchases.

Recent data (2000-2005) show that very large programs (companies retiring 15 to 20 percent of shares) lead to better share price performance than the giant programs (20 percent-plus). the larger the program—the higher the percentage of the shares outstanding the company actually retires—the greater management’s conviction. Relatively high insider ownership better aligns the economic interests of managers and shareholders. Spring 2000. • • Page 8 Legg Mason Capital Management . All things being equal. Sizable premiums reflect management’s belief the shares are undervalued and a willingness to act. Securities Data Corporation. “What Do We Know About Stock Repurchases?” Journal of Applied Corporate Finance. and LMCM estimates. Insider ownership. 14 Premium to market. a few factors point to management’s conviction that the shares are undervalued: 13 • Size of buyback program. Buyback details also affect the interpretation of the signal. Since 2000. Ikenberry. companies that have tendered at a premium delivered excess returns versus the S&P 500.Exhibit 5: The Waning Signal: Types of Buyback Programs Privately Negotiated Purchases 0% 0% 0% 0% 0% 11% 14% 7% 6% 6% 9% 17% 4% 4% 2% 16% 6% 7% 2% 2% 1% 3% 5% 3% 2% 3% 5% Fixed Price Tender Offers 0% 31% 27% 37% 41% 40% 17% 8% 9% 3% 8% 4% 3% 2% 5% 1% 2% 2% 2% 1% 9% 1% 1% 2% 1% 1% 4% Year 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005E TOTAL Open Market 100% 69% 73% 63% 59% 45% 62% 82% 68% 84% 78% 76% 87% 90% 92% 83% 91% 88% 95% 94% 88% 95% 93% 94% 95% 93% 88% Dutch Tender Offers 0% 0% 0% 0% 0% 3% 7% 3% 17% 7% 5% 4% 5% 3% 1% 1% 2% 3% 1% 3% 2% 0% 1% 2% 2% 3% 3% Source: Gustavo Grullon and David L. Specifically. Managers with relatively significant equity will more likely invest only in value-creating opportunities than maximize firm size.

This risk adds ambiguity to the buyback signal. In gauging the credibility of a buyback’s signal. management actions and the guiding principle of buybacks often come into direct conflict. and the size of the tender offer and the premium to market increases Return cash to shareholders Company receives tax Buy "undervalued" stock efficient return on Change capital structure purchase price of shares Offset stock option dilution for period specified in forward contract Return cash to shareholders Buy "undervalued" stock Change capital structure If investors do not heed positive signal. premium paid over market price can result in wealth transfer from ongoing shareholders Stronger than gradual repurchase. as firm buys back shares immediately Can be strong if firm previously over-invested excess cash Strong positive signal Strength of signal increases if insiders do not tender. they neglect investment needs. and the size of the tender offer and the premium to market increases Return cash to shareholders Buy "undervalued" stock Change capital structure Private Offers higher risk of undersubscription than Dutch auction Usually associated with Can be used to buy back "greenmail" shares from shareholder Management typically pays who wants to sell premium Lowers cost of repurchase if stock price goes up Negative signal. investors are well off to heed the age-old adage that actions speak louder than words. but Most flexible method Can time repurchases to not completed offset dilution from Gradual Open Market options Share Repurchase Inexpensive Gradually increases earnings per share by lowering share count Can be structured to be flexible Inexpensive Accelerated Share Immediately increases Repurchase earnings per share by lowering share count Usually results in permanent increase in stock price from strong positive signal to market Offers lower risk of Dutch Auction Tender undersubscription than Offer fixed price tender Range of prices allows market forces to determine amount of shares tendered Usually results in permanent increase in stock price from strong positive signal to market Fixed Price Tender Often used to increase Offer value via leveraged recapitalization If investors do not heed positive signal. Finally. This action sends the market a positive signal. especially for open market programs.• Insider selling. they increase their personal bet on the company’s success. acceptable methods. as management displays willingness to transfer wealth from ongoing shareholders Income from writing put warrants is tax-free to company Avoid takeover Puts/Collars Hedge against share price appreciation Source: LMCM analysis. Earnings per share do not explain value effectively because they do not incorporate the cost of capital. The researchers focus on companies that aggressively deploy discretionary tools—a means to manipulate earnings—and find the companies suffer from poor operating performance over the long term. The analysis suggests these companies announce buybacks to boost the stock price in the short term. Exhibit 6: Benefits and Drawbacks of Various Buyback Approaches Benefits Drawbacks Strength of Signal to Market Typically weak Can be strong if firm previously over-invested excess cash Depends on management credibility Tax Benefit Common Reasons for this Method Return cash to shareholders Buy "undervalued" stock Change capital structure Offset stock option dilution May be announced. and companies can compute them using alternative. a recent study suggests a number of repurchase programs are announced with the intention of misleading investors. Exhibit 6 summarizes the various buyback approaches along with their benefits. Page 9 Legg Mason Capital Management . drawbacks and common motivations. 15 2. When managers execute a sizeable buyback program and indicate they will not sell any of their shares. To Manage Earnings per Share When management announces a share buyback for the purpose of managing earnings per share. premium paid over market price can result in wealth transfer from ongoing shareholders Strong positive signal Strength of signal increases if insiders do not tender.

B. (See Exhibit 7. (As disturbing. We can see that earnings per share rise for company A. Page 10 Legg Mason Capital Management .) Second. earnings-per-share accretion or dilution has nothing to do with whether a buyback makes economic sense because the relationship between the P/E and the interest rate dictates the accretion or dilution. we will see. Repurchasing overvalued shares or refraining from buying undervalued shares because of the unfavorable earnings-per-share impact is shareholder-unfriendly finance. a buyback reduces earnings per share. When the earnings yield is less than the after-tax interest rate. and decline for company C. many investors believe this. and earnings per share. A buyback of an overvalued stock can add to earnings per share while decreasing value for continuing shareholders and a buyback of an undervalued stock can reduce earnings per share while enhancing value for ongoing holders. Here’s a very simple example. B. many executive compensation schemes are partially tied to earnings targets. while the relationship between price and expected value dictates a stock buyback’s economic merits. and two shares. Whether a buyback program increases or decreases earnings per share is a function of the price/earnings multiple and either the company’s forgone after-tax interest income or the after-tax cost of new debt the company uses to finance the buyback. The EPS management motivation has no sound financial basis. operating income. as well. More concretely. Only their stock prices are different. Thus. The relationship between the earnings yield and the after-tax interest rate has little or nothing to say about value. managements persist in their efforts to maximize earnings per share—sometimes. the notion that buybacks of high-P/E stocks are bad. and C can buy ten. Why? First. remain unchanged for company B. or that buybacks of low P/E stocks are good. defies economic reasoning. three. shares outstanding. A. respectively. Note that the changes in earnings per share are completely independent of the relationship between price and expected value. at the expense of maximizing value. a buyback adds to earnings per share. and C) have identical $100 cash balances. when the inverse of the price/earnings multiple— often called the earnings yield—is higher than the after-tax interest rate. Similarly. Assume three companies (A.Nevertheless.) Now assume each company uses its $100 cash balance to buy back stock. tax rates. they often believe the investment community mechanically and uncritically applies a multiple to current earnings to establish value.

0% Company B $95 $5 $100 $40 $60 60 $1.00 $10. 16 We strongly believe that managers should weigh the merits of a buyback and a compensation program separately.3 3.00 50. companies buying back stock to offset dilution are not necessarily destroying value for ongoing shareholders.98 Operating income Interest income Pretax income Taxes (at 40%) Net income Shares repurchased Shares outstanding Earnings per share Source: Rappaport and Mauboussin. Although evidence suggests that part of the surge in share repurchases in the 1990s was related directly to countering the potentially dilutive impact of option grants.00 10.0% Company C $95 $5 $100 $40 $60 60 $1. Buybacks effected solely to offset dilution from employee stock option programs risk destroying shareholder value for ongoing shareholders.0% Operating income Interest income ($100 at 5%) Pretax income Taxes (at 40%) Net income Shares outstanding Earnings per share Stock price P/E E/P After-tax interest rate Company Comparison after Share Buyback Company A $95 $0 $95 $38 $57 10 50 $1. research shows the market reacts less favorably to repurchases by companies with substantial option programs. Over 30 percent of the S&P 500 companies repurchasing since 2000 have not seen a net shrinkage in shares outstanding.0 2.Exhibit 7: EPS Impact of a Share Buyback Company Comparison prior to Share Buyback Company A $95 $5 $100 $40 $60 60 $1. In this case.0% 3.14 Company B $95 $0 $95 $38 $57 3 57 $1. On the other hand.33 33.00 $33. The argument against this motivation runs similar to the one against EPS management: the magnitude and timing of the buybacks have nothing to do with the price-to-value gap. 179-180. To Reduce Dilution from Employee Stock Options A substantial percentage of executives cite ESO dilution management as an important input in their share-repurchase decision. the outcome can be consistent with creating value. as some pundits assume.0% 3.0 10.00 $50. 3.0% 3.00 Company C $95 $0 $95 $38 $57 2 58 $0. Even if the motives are not correct. Page 11 Legg Mason Capital Management . companies aim to buy enough shares to keep the level of outstanding shares constant.

LMCM analysis..00 0.S.00 0. 511 . Increases in financial leverage can be beneficial beyond the capture of tax shields. which enhances shareholder value. the suggestion that leverage is a source of value creation from buybacks is less clear. Capital structure determines whether a firm pays out operating income as interest expense or as equity income. debt financing is slightly more desirable than equity financing. is currently 35%) and taxes equity income at both the corporate rate (35%) and on the personal level (15% for long-term capital gains). (See Exhibit 9. Exhibit 8: Optimal Capital Structure Market value PV (costs of financial distress) PV (tax shield) Optimal debt ratio Value if all-equity financed Debt ratio Source: Richard A. buybacks efficiently increase the debt/equity ratio for underleveraged firms.00 1.65 Equity income $1. 2000).S. Myers.19 The U. government taxes interest at the personal level (the top rate in the U. (See Exhibit 8). Specifically. changes in the tax law have made debt relatively less attractive than equity. Share repurchase can play a central role in changing a company’s capital structure. (New York: McGraw Hill.35 $0.05 $0. Source: Brealey and Myers. Specifically. 17.) Exhibit 9: The Advantage of Debt versus Equity Financing Operating income Corporate tax (@35%) Income after corporate tax Personal tax (@ 35%) Capital gains tax (@15%) * Income after all taxes Interest $1. As a result. high interest expense payments mean a company has less discretionary cash to invest in valuedestroying projects. Despite evidence that incorporating debt into the capital structure can increase firm value.35 0. forcing management to submit to the market’s judgment every time it wants to raise capital to Page 12 Legg Mason Capital Management . 18 Further.60 (*) = Assumes the effective capital gains rate is 50% of the statutory rate. Brealey and Stewart C. 6th ed. debt serves as a built-in check on the capital allocation process.65 0. As such.4. Principles of Corporate Finance. This minimizes the cost of capital. up to a point. To Increase Financial Leverage. An appropriate level of financial leverage results in an optimal capital structure—a healthy balance between beneficial tax shields and the risk of financial distress.

Too much debt can lead to an inability to meet contractually obligated commitments. be it debt or equity. Second is the adjusted present value (APV) method. changes in corporate. Page 13 Legg Mason Capital Management .22 APV determines business value by summing its unlevered value and the value of its financial strategy. Managers should weigh the benefit of financial leverage against the potential cost. a company can generally raise the capital required to fund value-creating projects. Investors are well served to study the issues around buybacks. tax-deductible interest expense creates a valuable tax shield.23 The current tax code slightly favors the prudent use of debt.20 Other relevant capital structure considerations include the following: • The value of a tax shield is measurable. APV offers more flexibility than capitalizing tax shields because it accommodates changing capital structures. Varying tax rates complicate the debt versus equity decision. Financial distress is onerous. While buybacks reached record levels in 2005. even for a business with healthy cash flows. rapidly and cheaply. Second. As seen above. If shareholders can redeploy funds at a rate higher than what the cash earns. understanding how a company is likely to allocate capital is more important than ever. 21 You calculate this by dividing the tax savings (interest expense times the marginal tax rate) by the pretax cost of debt. personal. At a certain point. the company should return the capital to shareholders. Indirect costs include forgone business with suppliers and customers uncertain about the future of a financially distressed firm. For a company with positive pretax profits. and capital gains tax rates can amplify or dampen the advantage of debt versus equity financing. The first approach. with substantial direct and indirect costs. First. and insist the companies they invest in do the right thing.invest. which assumes a permanent change in capital structure. the motivations behind buybacks do not always follow solid economic reasoning. 24 We can define financial flexibility as the ability to quickly access capital for an attractive investment opportunity or to weather a business downturn. Direct costs include legal and administrative fees in bankruptcy. investors generally cheer debt-increasing financial maneuvers with a higher stock price. the risks of financial distress outweigh the benefit of debt. is to capitalize the tax savings. We can estimate the value of this shield using one of two ways. Unsurprisingly. especially for companies largely reliant on intangible capital. This option has questionable value for a couple of reasons. managers often do not take into account the opportunity cost of excess capital parked on the balance sheet. • • • Conclusion Given the substantial overcapitalization of many companies in America today. What about financial flexibility? Managers often argue that a conservative capital structure is important in order to maintain financial flexibility.

25 But ROE.0 0. Inflation during the same period averaged 3 to 4 percent. 26 On the surface. If today’s ROE persists.70 1Q02 2Q02 3Q02 4Q02 1Q03 2Q03 3Q03 4Q03 1Q04 Asset Turnover Leverage 2Q04 3Q04 4Q04 1Q05 2Q05 3Q05 2. Financial leverage will decline further.7 2. Morgan Stanley.8 2. They argue the rise of platform companies leads to greater capital efficiency. yielding nominal earnings growth of 6 to 7 percent. Alternatively. ROE’s can come down.90 Asset Turnover 2.80 0. But the aggregate ratio obscures the sharp rise in goodwill as the result of robust mergers and acquisitions activity in the last 10-15 years. An increase in payout ratios via dividends and buybacks is the most likely of these scenarios. See Exhibit 10.1 3.6 3.Appendix A: Why This Issue May Not Go Away Soon Return on equity (ROE) has substantial limitations as a measure of economic returns. Further. and there has been a steady drumbeat from investors encouraging more leverage. Returns on tangible operating assets have been rising steadily. one of the equation’s factors has to change: • • • Earnings growth will exceed historic rates. reflecting high margins and average ratios for asset turnover and financial leverage. So what’s the chance ROE’s will remain at today’s lofty levels? In their book. The payout will rise. when combined with corporate payout policy. In turn. Exhibit 10: Asset Turnover and Leverage (S&P Industrials) 0. we can decompose ROE using the DuPont formula: ROE = net margin x asset turnover x financial leverage The S&P 500’s estimated 2005 ROE of roughly 18 percent is above-average. the GaveKal researchers point to the emergence of platform companies—entities that focus mostly on product design and marketing and outsource manufacturing to countries with lower labor costs.9 2.4 Source: Compustat. as well as the substantial buildup of excess cash. as asset turnover ratios are just average. Corporate America is arguably already underleveraged.75 0. reverting toward the cost of capital. We find this unlikely because aggregate growth is governed by macro factors like GDP growth. Our Brave New World. and higher returns on equity. can provide some basic insights into the composition of growth. Simply.85 Legg Mason Capital Management . lower volatility.95 0. we can state: Earnings growth = (1 – payout ratio) x ROE Over the last fifty years. the data do not seem to support the thesis. Page 14 Leverage 0.5 2. asset turnover ratios have risen sharply and leverage ratios have dropped significantly in recent years. the payout ratio (heavily determined by dividends until the mid-1980s) has been just over 50 percent and ROE in the 12 to 13 percent range.

Page 15 Legg Mason Capital Management .While more platform companies suggest less capital intensity in the U. option grants appear to have been strongly correlated to market performance.. As it turned out. As we will see. option grants and the mental models surrounding them play a significant role in how companies evaluate dividend and buyback tradeoffs. the shift also implies greater investment in people.S. however. The sharp rise in employee stock grants in the late 1990s seemed to strongly reaffirm this perspective. The value of option grants for S&P 500 companies peaked at over $100 billion in 2000 and slid to a level below $40 billion in 2004.

2 Present Value at Time 4 PV cash flows 131.0 Present Value at Time 0 PV cash flows 92.389.) Exhibit 11: Hypothetical Company Growth Cost of Capital Period Cash flows 9% 8% 1 100. At the end of the last time period the cash flow stream is worth $1.1 104.6 Plus realized cash Total value 1.0 2 109.2 Plus realized cash 217.750.3 Present Value at Time 5 PV cash flows 925.5 96.Appendix B: Demonstration that Dividends and Buybacks are Equivalent The best way to demonstrate the equivalence of dividends and buybacks looks simply at the numbers.0 121.3 Present Value at Time 3 PV cash flows 120.3 Assumes: *Dividends/repurchase occur on last day of the year *Dividend/repurchase proceeds are reinvested at the cost of capital *Stock price is at "fair value" at year-end Source: LMCM.5 Total value 1. We then value the company at each time period.3 Plus realized cash 353. Neither the pattern nor the longevity of the cash flow streams affects the result of the analysis.8 857.00 5 141.1 103. there is no need to assume investors reinvest at the cost of capital.5 735. Exhibit 11 shows a stream of distributable cash flows for a hypothetical company.5 95.0 93.1 Shares outstanding Share price (t0) 3 119.2 680.1 4 129.3 Plus realized cash 511.9 $ 110.286.4 Total value 1.750.000.8 6 1.8 Present Value at Time 1 PV cash flows 101.1 Total value 1. assuming the investor reinvests the cash flows at the cost of capital. (In fact.4 Present Value at Time 6 PV cash flows Plus realized cash 1.2 102.28 10.750.5 793.0 Total value 1.5 630.5 94.9 Plus realized cash 694. Page 16 Legg Mason Capital Management .0 Total value 1.0 Plus realized cash 100. we just need to assume they reinvest at the same rate.102.0 Present Value at Time 2 PV cash flows 110.500.191.6 111.620.7 Total value 1.4 112.

0 91.3 101.5 511.4 1.1 119.2 1.0 109.02 Adjusted value 1.0 217.7 63.000.87 # Shares buyback 9.0 12.60 28.0 Reinvestment 8. In the first.0 $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ $ Source: LMCM. the company repurchases stock with the funds (see Exhibit 13).6 925. Exhibit 12: Cumulative Dividend Value Year 1 2 3 4 5 6 Source: LMCM.1 353. under the following assumptions: • No taxes • No transaction costs • Dividend and share repurchase proceeds are reinvested at the discount rate • Dividends and share repurchases occur on the last day of the year • The stock price is at fair value at year-end Of course.69 40.2 1.5 9.9 141.60 14.1 119.091.9 141.000. The analysis shows these two means of returning cash to shareholders are identical.0 Value/ share 10.9 Buyback value 100.069.66 8.67 63.750. the company pays the cash out in the form of a dividend (see Exhibit 12).0 1. Still.1 129. Current payment 100.750. Exhibit 13: Share Repurchase Program Year 1 2 3 4 5 6 Starting shares 110.8 1.60 17.389.191.4 28.21 72.0 Adjusted shares 101.9 55.9 55.80 11.We now consider two scenarios.0 In the second. the underlying principle is a central one: managers can return cash to shareholders using either dividends or share repurchase. Investors seeking current yield under the share repurchase scenario can simply sell a proportionate amount of their shares to create liquidity.4 1.0 Price Reinvestment 10.7 82.1 129.3 1.4 13.2 72. Page 17 Legg Mason Capital Management .0 109.3 14.500.0 1.6 Total value 1.6 63.67 82.6 Total value 100.02 91.69 15.3 9.620.7 988.3 1.5 9.7 694.4 9. reality is messier than the sterile world the model assumes.0 17.035.8 1.80 11.286.3 40.66 12.60 13.

We start with the formula for the percent increase in intrinsic value per share: % Increase in Intrinsic Value per Share = Post . then. this discount persists.0 160 840 10. See Exhibit 14. She uses the firm’s $160 in cash to purchase 20 shares at the market price of $8 per share.000 8.Buyback Intrinsic Value per Share = Pre .000 to $840.Buyback Intrinsic Value Share .00 10. See Exhibit 15. In our example. no alternative action can benefit shareholders as surely as repurchases.Shares Repurchase d The cash spent on the repurchase is simply the equity market capitalization of the firm times the percentage of the shares the company repurchases.0 80.Cash Spent on Repurchase Initial Share Count .50 5.Appendix C: How Buying Back Undervalued Shares Can Increase Shareholder Value In Berkshire Hathaway’s 1984 annual report. “When companies with outstanding businesses and comfortable financial positions find their shares selling far below intrinsic value in the marketplace. intrinsic value rises from $10 to $10. The analysis provides a formula to determine how much a company can increase its per-share intrinsic value by buying back undervalued shares.” Here we develop this point through an example and formal proof.Buyback Intrinsic Value/Shar e Next. Page 18 Legg Mason Capital Management . $ $ $ $ 800 1. Warren Buffett noted. $ $ $ 20. Despite communicating the firm’s excellent prospects to investors. On a per-share basis. a CFO correctly believes that the market undervalues her $10 stock by 20%. we can calculate Post-Buyback Intrinsic Value per Share as: Post . from $1.00 100.0% We can derive a formula to yield the same result. This lowers the intrinsic value of the firm by the $160. However.0 The CFO decides to take advantage of this opportunity by repurchasing 20% of the outstanding shares. Exhibit 14: CFO’s Perception versus Market Reality Trading value of total firm Intrinsic value of total firm Trading value per share Intrinsic value per share Shares outstanding Source: LMCM analysis.50—an increase of 5%.Buyback Intrinsic Value/Shar e -1 Pre . the firm now has 20 less shares. Exhibit 15: Intrinsic Value Rises after Buying Undervalued Shares Shares repurchased New shares oustanding Amount of cash needed to finance buyback New intrinsic value of firm Intrinsic value per share Increase in intrinsic value per share Source: LMCM analysis.

Plugging these formulas into one another and canceling out terms.(% of Shares Repurchased x Stock Price )) Intrinsic Value .1 = . we find that both methods give us the same 5% increase in intrinsic value per share.% of Shares Repurchased) % Increase in Intrinsic Value/Share = Testing this equation against the answer given by our spreadsheet.(20% x % Increase in Intrinsic Value/Share = $8 )) $10 .8) .(0.8 . (1 .8 (1 .2 x 0.20%) Page 19 Legg Mason Capital Management .1 = 1 . we arrive at the formula: (1 .1 (1 .1 = 5% 0.84 .

which means a lower stock price. as debt is a prior claim on cash flows. a lower risk level translates to a lower discount rate. Equity investors in public companies generally require a return in the neighborhood of 7% to 10%.000 = $869. while venture capital investors demand 20% to 30% returns.000 cash flow is the same for both entities. albeit with a higher demanded rate of return to compensate for the higher business risk inherent in Internet startups. Page 20 Legg Mason Capital Management . we can calculate that the present value of the startup’s promise is a much lower $869. The more risk. we turn to the standard discounting formula: Present Value = Cash Flow (1 + Demanded Rate of Return) number of years before you receive the cash flow If we value the government’s promise to pay $1.04) Similarly. Whatever the cost of equity investors demand. Conversely. the higher riskiness of the startup’s promise makes it less valuable. while the timing and magnitude of the $1. we find that this promise’s present value is $961. we can value the startup’s same promise.54.57 (1. Consequently. Say two entities make separate promises to pay an investor $1.S. To value these promises. government while the second entity is a risky high-tech startup company backed only by the start-up’s uncertain earnings power. If an investor were to sell both IOUs to a third party. it’s natural to expect that the risk-free promise from the Treasury would be worth more than the riskier promise from the startup. Indeed. debt can make equity more expensive. which means a higher stock price. A Simple Example Here’s a simple example. however.000 next year. Present Value = $1. This is true whether we are talking about investors purchasing stock for their portfolios or companies repurchasing their shares in the open market. Put more formally.57.Appendix D: Why a Stock Buyback Earns the Cost of Equity in an Efficient Market One basic principle in capital markets involves the trade off between risk and reward. the U. the price of a stock should adjust so as to earn at least that return. is backed by the full faith and credit of the U. Treasury.000 (1 + 15%) 1 = $1. The first entity. higher risk translates into a higher discount rate. Stocks lie somewhere in the middle of this range.15) This simple example highlights that different prices have different embedded demanded rates of return.000 (1 + 4%) 1 = $1. investors in risk-free government bonds accept returns of less than 5%. investors will bid stocks up and down until it becomes very difficult for an investor to earn more than the cost of equity.S.000 a year from today using a risk-free rate of 4%. All things equal.54 (1.000 = $961. varying from the stable cash flows of a utility to the volatile cash flows of a startup. Using a higher discount rate of 15%. Present Value = $1. the higher the return an investor will demand. This number is not set in stone because each company faces a different risk profile. In addition. in an efficient market.

. we created pro forma financial statements for a hypothetical company with a constant return on capital of 18%. After all. Exhibit 16: Discounted Cash Flow Analysis for a Company Economic Profit Method of Valuation Year Invested Capital (t) Cash Earnings (t) Return on Capital (%) Cost of Capital (%) Excess Return (%) Economic profit ($) PV of Economic Profit (t) Perpetuity of Economic Profit Σ PV of Economic Profit (0 . we translate these pro forma statements into a standard discounted cash flow analysis.. the CAP will shorten. t) PV of perpetuity Beginning Invested Capital Core Enterprise Value Excess Cash Total Enterprise Value Shareholder Value Price per share Price to cash earnings multiple FCF Method of Valuation Year Cash Earnings (t) Annual Investment (t) FCF (t) PV of FCF (t) Σ PV of FCF (0 . This calculation values the company at $968 million. We assume the company has a competitive advantage period (CAP) of five years—that is..0% 10% 8% 44 33 413 104 311 500 915 4 579 104 18. The other important difference is that the company will have generated a certain amount of excess cash.094 679 968 968 6 109 109 $ $ 968 968 10. To do this. and cash earnings that start at $90 million. This cash in hand is the result of $65 million of free cash Page 21 Legg Mason Capital Management .8 1 500 90 18. we also assume the company has no debt and investors use a 10% cost of equity to discount the company’s cash flows. This growth also necessitates additional capital expenditure. t) Perpetuity of Cash Earnings (t) PV of perpetuity (t) Core Enterprise Value Excess Cash Total Enterprise Value 1 90 25 65 59 59 900 818 877 2 95 26 68 56 115 945 781 896 3 99 28 72 54 169 992 745 915 4 104 29 75 51 221 1. as the increasing annual investment during that same period reflects. since a year has elapsed and there is no change in the business plan. realistic example as well.0% 10% 8% 42 35 394 71 325 500 896 3 551 99 18. Finally. This will give us the share price an investor would expect to enjoy with no change in the company’s business plan and the passing of a year. For computational convenience.042 712 932 5 109 109 68 289 1. Next. the most important difference will be the natural shortening of the CAP—the period during which the company can generate excess returns—from five to four years.0% 10% 8% 49 30 486 166 302 500 968 968 6 608 109 Source: LMCM analysis. we repeat this exercise for the company after a year has passed.0% 10% 8% 46 32 434 136 297 500 932 5 608 109 18. See Exhibit 16. that investors believe the company will grow revenues for five years (at a modest 5%). While expected cash flows for this company will remain the same.A Realistic Example We can also demonstrate this with a more complex.0% 10% 8% 40 36 375 36 341 500 877 2 525 95 18..

Thus. t) Perpetuity of Cash Earnings (t) PV of perpetuity (t) Core Enterprise Value Excess Cash Total Enterprise Value 1 95 26 68 62 62 945 859 921 2 99 28 72 59 121 992 820 941 3 104 29 75 57 178 1.000 65 $ 1. in addition to the $1 billion in value from the company’s core operations.065 5 109 109 109 362 Source: LMCM analysis. this 10% increase in value means that investors earn exactly their demanded cost of equity of 10%..065 billion.0% 10% 8% 46 35 434 109 326 525 961 4 608 109 18.0% 10% 8% 49 33 486 143 332 525 1.3 5 608 109 FCF Method of Valuation Year Cash Earnings (t) Annual Investment (t) FCF (t) PV of FCF (t) Σ PV of FCF (0 .065 11. The logic starts with the premise that a stock’s value is the present value of all future equity free cash flows. Exhibit 17: Discounted Cash Flow Analysis for a Company after One Year Economic Profit Method of Valuation Year Invested Capital (t) Cash Earnings (t) Return on Capital (%) Cost of Capital (%) Excess Return (%) Economic profit ($) PV of Economic Profit (t) Perpetuity of Economic Profit Σ PV of Economic Profit (0 .. As theory predicts. Interestingly. although the company’s business plan and investors did not change at all.042 783 961 4 109 109 75 253 1.094 747 1..0% 10% 8% 44 36 413 75 342 525 941 3 579 104 18.. A Theoretical Proof A hardened skeptic may want more than examples to prove that the expected return on any stock— whether an open-market purchase or a company buying back stock—is the cost of equity. Here’s a proof demonstrating this relationship always holds.0% 10% 8% 42 38 394 38 358 525 921 2 551 99 18. t) PV of perpetuity Beginning Invested Capital Core Enterprise Value Excess Cash Total Enterprise Value Price per share Price to cash earnings multiple 1 525 95 18.000 65 $ 1.flow in its first year. investors will give the company credit for an extra $65 million from this cash in hand.065 $ 1. See Exhibit 17. the company’s value goes from $968 million to $1. discounted at the cost of equity: Page 22 Legg Mason Capital Management .

Page 23 Legg Mason Capital Management . If we maintain the convention of calling the free cash flow (FCF) in each year by the same year number we used previously. we can equate the two: PV 1 = PV 0 x (1 +k e) Thus.∞ Present Value (in Year 0) = ∑time =1 Free Cash Flow time (1 + cost of equity) time The formula for the value of a stock in a year is very similar.17 FCFtime ∞ x (1 +k e) PV 0 x (1 +k e) = ∑ time =1 (1 + k e) time Canceling out the numerator and denominator on the right side of this equation. the formula is: ∞ Present Value(in Year1) = FCF 1 + ∑time=2 FCF time (1+ cost of equity)time-1 where FCF1 represents the cash-in-hand that results from the free cash flow that the company generated in its first year of operation. we arrive at this equation: ∞ PV 0 x (1 +k e) = ∑time =1 FCFtime (1 + k e)time -1 We can expand the summation to arrive at this equation: ∞ PV 0 x (1 +k e) = FCF1 + ∑time =2 FCFtime (1 + k e)time -1 Because this equation describing the present value of a stock in year 0 is exactly equal to the previous equation describing the present value of a stock in year 1. If we multiply both sides of the first equation by the quantity (1 + cost of equity). we arrive at the following equation. we arrive at our conclusion: the value of a stock next year is equal to the current value of a stock multiplied by 1 plus its cost of equity. after several algebraic manipulations.

Thus.Appendix E: Why an Asset-Sale-Financed Stock Buyback Can Be Dilutive to Earnings but Additive to Shareholder Value With Wall Street so focused on earnings per share growth. In our example. Take for example a company with two divisions. the two divisions have a combined market capitalization of $1.050 100 10. an 8% growth rate. and zero net investment. if the sale results in lower earnings per share. For instance. See Exhibit 18. Source: LMCM analysis. After the company returns the $100 in cash to shareholders by repurchasing 9. This is particularly true for companies that have executive compensation programs tied to EPS targets.050. we should expect that many corporate managers work to boost earnings per share and avoid diluting earnings at all costs. Should management accept this offer? The accounting and economic analyses give different answers. Dog division’s value is $50. [$50 = $5/10%. as it now has $100 in cash versus owning a business worth $50. many accounting-focused managers avoid selling value-destroying divisions.50 per share. before the company repurchases its shares. even at a price above intrinsic value. the company’s value will fall back to $1.] The second business. earns a return on invested capital of 40% on $50 of invested capital. this translates to a price of $10. another firm approaches our company and offers to buy the assets of Dog for book value of $100. However.00 0. the share price would jump to $11 to reflect this improvement. Accordingly.000.20 0. Cash Cow.000 $ 50 $ $ $ $ 1. many managers like share repurchase for precisely that reason. Exhibit 18: A Tale of Two Divisions "Cash Cow" "Dog" Division Division $ 20 $ 5 50 100 0.8%). As management has no investment needs. the per-share value of our Page 24 Legg Mason Capital Management . firm value jumps from $1.100. An economic analysis indicates that the company is now worth $50 more. the standard perpetuity present value formula tells us the business is worth $1. the Dog division. they would return this money to shareholders via share repurchase.25 42 x Cash earnings Invested capital Earnings per share contribution Return on invested capital Growth in cash earnings Value Market value of total firm Shares outstanding Price per share Total earnings Earnings per share Price-to-earnings ratio Note: Assumes 10% cost of capital and that capital expenditures equal depreciation. The first division. we argue that executives should dwell on the economic consequences of such a decision.050 to $1. A no-growth business. as there will now be only 90. With 100 shares outstanding. [$1000 = $20/(10% . Indeed.1 shares. earns only a 5% return on its $100 of invested capital.] Accordingly. This amount is double Dog’s intrinsic value. the accounting consequences of share buybacks are not always positive. Not surprisingly. Assuming a 10% cost of capital. Buybacks have become a popular way to augment earnings per share.50 25.9 shares outstanding. However.05 40% 5% 8% 0% $ 1.000.

50.000 100.company would remain at $11. the economic analysis gives a green light to selling the Dog division.00 $ $ 20 0. a 4. See Exhibit 19. Even with fewer shares outstanding.22 per share or 12% dilution versus the prior total. Given the reported earnings per share drop. The accounting analysis points the other way. Exhibit 19: Economic and Accounting Analysis of an Asset Sale-Financed Share Repurchase Cash Cow Alone $ 1. Selling Dog will result in losing $5 in earnings power. Clearly. many managers would incorrectly choose to pass on this value-creating opportunity.0 9. this translates into earnings of $0.9 $ 11. Page 25 Legg Mason Capital Management .22 50 x Market value of total firm Old shares outstanding Shares repurchased New shares outstanding New price per share New net income New earnings per share New price-to-earnings ratio Source: LMCM analysis.8% increase from $10.1 90.

60. Inmoo Lee. vol. 17 John R. “How Big Are the Tax Benefits of Debt?” Journal of Finance. 12 William McNally.” Journal of Finance. “When a Buyback Isn’t a Buyback: Open Market Repurchases and Employee Options. Ikenberry. vol. 5. and Roni Michaely.” Journal of Applied Corporate Finance. 1 Page 26 Legg Mason Capital Management .” Journal of Financial Economics. Summer 1991. November 2005. 2001). see James M. The Value Imperative: Managing for Superior Shareholder Returns (New York: Free Press. and Inmoo Lee. 2005. Harvey. 53. 18 Konan Chan. “Share Repurchases as a Tool to Mislead Investors: Evidence from Earnings Quality and Stock Performance. 22 Timothy A. Brealey and Stewart C. May-June 1997. David Ikenberry.” Journal of Applied Corporate Finance.” The Wall Street Journal. Kahle. 23 Merton H. 11. vol. 3 Andrew Bary. 59. 174. 7 Alon Brav. Fall 2004. June 11. 2005. “Debt and Taxes. 16 Kathleen M. Jensen.zhtml?c=103274&p=irolnewsArticle&ID=793423&highlight. October 2000. Campbell R. April 2004.” Tuck Contemporary Corporate Finance Issues III Conference Paper. vol. 651-680. Graham. 2.” Harvard Business Review. 20 Michael C. “How Much Cash Does Your Company Need?” Harvard Business Review. 19 Richard A. 21 For a more complete and sound approach. 235-261. 9. 139-183. without interest. 9 Brav. annd Yanzhi Wang. November 2005. “Taking the Measure of the World’s Cash Hoard. Graham. 313-333.” Journal of Finance. September 30.00 per share.com/phoenix. Miller. MA: Harvard Business School Press. 261-275. David L. February 1998. 55. November 2003.” Credit Suisse First Boston Research. Myers. 13 Theo Vermaelen. May 1977. “Under the terms of the tender offer. “Reappearing Dividends. see Ulrike Malmendier and Geoffrey Tate. 1. According to the company. 239-255. September 2004. “The Information Content of Share Repurchase Programs.” Journal of Finance. 2005..Endnotes Greg Ip. vol. 1981. Kontes. “Who Wins in Large Stock Buybacks—Those Who Sell or Those Who Hold?” Journal of Applied Corporate Finance. net to the seller in cash. The tender offer will expire Dec. “Common Stock Repurchases and Market Signaling. 13. 8 Alfred Rappaport and Michael J. “Hot Money. Yanzhi. 5 For an excellent discussion of resource allocation. and Michaely. 2661-2700. Graham. 24 Richard Passov. 4 For an interesting discussion of capital allocation and incentives. 6. Luehrman.” Empirical Research Partners. 1901-1941. and Martha deLivron. Inc. 32. 2000). Mauboussin. vol. 14 Konan Chan. and Michael C.” Birinyi Associates. 2005. 78-88. 2001. unless extended. John R. Goldstein.00 per share and not greater than $37. 6th edition (New York: McGraw Hill.” See http://www. November 14. 2. 2005. 1994). 25 Michael J. February 2002. November 3. 6 Brandon Julio and David Ikenberry. 15 Laszlo Birinyi Jr. Agilent is offering to purchase up to 73 million shares of its common stock at a price not less than $32. “Using APV: A Better Tool for Valuing Operations. Spring 1998. “Where’s the Bar? Market-expected Return on Investment as a Performance Hurdle. November 7. 2 Michael L. 1.” Journal of Financial Economics. “The Buyback Paradox: Part II—Topical Study #33. see Gustavo Grullon and Roni Michaely.investor. “CEO Overconfidence and Corporate Investment. McTaggart. 500-510. see Graham. Peter W. vol. Jeffrey Rubin.” Barron’s Online. “Economic Sources of Gain in Stock Repurchases” Journal of Financial and Quantitative Analysis.” AFA 2006 Boston Meetings Paper.agilent. “Corporate Control and the Politics of Finance. Principles of Corporate Finance. 2. 63. “Portfolio Strategy. vol. 10 Clifford Stephens and Michael Weisbach. Also. “Actual Share Reacquisitions in Open-Market Repurchase Programs. at 12:00 midnight ET. Mankins.” Journal of Finance. December 2005. Expectations Investing: Reading Stock Prices for Better Returns (Boston. Harvey. 11 One recent example comes from Agilent Technologies. “Payout Policy in the 21st Century. Mauboussin and Alexander Schay.

“Portfolio Strategy” Empirical Research Partners. Chan. and Michael C. and the Substitution Hypothesis. Anatole Kaletsky. 26 Resources Books Brealey. Ikenberry. and Stewart C. John R. “Economic Sources of Gain in Stock Repurchases” Journal of Financial and Quantitative Analysis. Linda DeAngelo and Douglas J. "Dividends. Gustavo and Roni Michaely.” Birinyi Associates. Birinyi. Jeffrey Rubin.. “Disappearing dividends: changing characteristics or lower propensity to pay?” Journal of Financial Economics. “Hot Money. Articles Amromin.. Rappaport. Chan. 1994). The Value Imperative: Managing for Superior Shareholder Returns (New York: Free Press. Brav. November 2005." AFA 2002 Atlanta Meetings. 1901-1941. Our Brave New World. “How Big Are the Tax Benefits of Debt?” Journal of Finance. Richard A. 55. David Ikenberry.Charles Gave. Grullon. Principles of Corporate Finance. Anatole Kaletsky. 3. (New York: GaveKal Research. October 2000. Mankins." AFA 2006 Boston Meetings Paper. 2005).” Barron’s Online. November 7. and Inmoo Lee. Gave. Kontes. Michael L. 2001). and Louis-Vincent Gave. 425-456. 2005. "Payout Policy in the 21st Century. French. 72. Fama. vol. November 14. and Yanzhi Wang. 2005. DeAngelo. and Roni Michaely. September 30.” Journal of Financial Economics. June 2004.. Graham. Gene. Gustavo and David L. 5. "Share Repurchases as a Tool to Mislead Investors: Evidence from Earnings Quality and Stock Performance. and Kenneth R. 2000). Bary. “What Do We Know About Stock Repurchases?” Journal of Applied Corporate Finance. 2005. Expectations Investing: Reading Stock Prices for Better Returns (Boston. June 2001. Goldstein. Mauboussin. Harvey. McTaggart. David L. Peter W. Inmoo Lee. April 2000. Share Repurchases. September 2004. Konan. and Martha deLivron. Konan. and Steve Sharpe. Our Brave New World (New York: GaveKal Research. vol. 60. “Are dividends disappearing? Dividend concentration and the consolidation of earnings. “How Did the 2003 Dividend Tax Cut Affect Stock Prices?” Federal Reserve Working Paper. Alfred and Michael J. Paul Harrison. November 2005. Grullon. 2005. Myers. Spring 2000. Ikenberry. Graham. vol. 2005)." Tuck Contemporary Corporate Finance Issues III Conference Paper. John R. Laszlo. Alon. Eugene F. 6th edition (New York: McGraw Hill. and Louis-Vincent Gave. MA: Harvard Business School Press. 3-43. Andrew. Harry. December 6. James M. Charles. Skinner. “The Buyback Paradox: Part II—Topical Study #33. Campbell R. Page 27 Legg Mason Capital Management .

vol. Spring 1998. Summer 1991. May 1977. Clifford. 63. 78-88. 2005. vol. “Using APV: A Better Tool for Valuing Operations. vol.” SSRN Working Paper. Fall 2004. and Michael Weisbach. 2. “Who Wins in Large Stock Buybacks—Those Who Sell or Those Who Hold?” Journal of Applied Corporate Finance. 261-275. Brandon and David Ikenberry.” Harvard Business Review. “The Information Content of Share Repurchase Programs. “Taking the Measure of the World’s Cash Hoard. Michael C. “CEO Overconfidence and Corporate Investment. Kathleen M. and Theo Vermaelen "The Many Facets of Privately Negotiated Stock Repurchases. and Geoffrey Tate. Kahle. “Corporate Control and the Politics of Finance. 139-183. Miller. Kahle. “Measuring Share Repurchases. 651-680. Theo. vol. Greg. 2.” Journal of Financial Economics.” Journal of Applied Corporate Finance. Vermaelen.. February 2002." EFA 2004 Maastricht Meetings Paper No. 53. Kathleen M. “Reappearing Dividends.” Journal of Applied Corporate Finance. 1. “Actual Share Reacquisitions in Open-Market Repurchase Programs. November 3. vol. 1731 and AFA 2004 San Diego Meetings..” Journal of Finance. August. vol. 2. 2661-2700. Merton H. 6. 11. “When a Buyback Isn’t a Buyback: Open Market Repurchases and Employee Options. 9. Gustavo and Roni Michaely. “How Much Cash Does Your Company Need?” Harvard Business Review. Passov. William. 313-333. Ulrike. Ip.. April 2004. January 2004. May-June 1997. Stephens. McNally.Grullon.. “Debt and Taxes. December 2005. 32. 1981. Julio. 59. 1.” Journal of Financial Economics. 2005. February 1998. Urs C. Richard. “Common Stock Repurchases and Market Signaling. Timothy A.” Journal of Finance.. November 2003.. Jensen. Peyer. Edward Alexander Dyl. Luehrman.” The Wall Street Journal. 60. vol. and Monica Banyi.” Journal of Finance. Malmendier. Page 28 Legg Mason Capital Management . 235-261.” Journal of Finance.

Not Bank Guaranteed. sold or recommended for clients of LMCM and it should not be assumed that investments in such securities have been or will be profitable. recommended to clients of LMCM. LLC. These views may not be relied upon as investment advice and. May Lose Value Legg Mason Capital Management is the investment advisor and Legg Mason Investor Services.The views expressed in this commentary reflect those of Legg Mason Capital Management (LMCM) as of the date of this commentary. The information provided in this commentary should not be considered a recommendation by LMCM or any of its affiliates to purchase or sell any security. because investment decisions for clients of LMCM are based on numerous factors. LLC is the distributor of five of the Legg Mason Funds. subsidiary Investment Products: Not FDIC Insured. or will in the future be. If specific securities are mentioned. Distributor . Employees of LMCM and its affiliates may own securities referenced herein. Legg Mason Investor Services. they have been selected by the author on an objective basis to illustrate views expressed in the commentary. Page 29 Legg Mason Capital Management . There is no assurance that any security mentioned in the commentary has ever been. and LMCM disclaims any responsibility to update such views. they do not represent all of the securities purchased. These views are subject to change at any time based on market or other conditions. Inc. To the extent specific securities are mentioned in the commentary.A Legg Mason. may not be relied upon as an indication of trading intent on behalf of the firm.

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