More Companies Should Eat Themselves

by JT McGee

I know that share repurchases are really unpopular as a way to return capital to shareholders. There is some weird belief that share repurchases are poorly timed and, at best, just a way to pay for stock-based compensation when shares are given out to executives.

I’ve heard it a billion times.

The argument ignores actionable information, however, in that a reduction in share count of any firm worth owning is obviously a good thing.

Consider This

Everyone knows what a P/E ratio is – it’s the price of the company divided by the annual earnings of the company. A company which sells for a PE of 10 would sell for a price 10 times its annual earnings. So, in 10 years, if you were to purchase the company outright, your purchase price would have been returned to you in earnings.

IBM currently sells for a PE of 14, which is reasonable for a tech services giant. Suppose that you were to purchase 1 share of the firm today for just under $200. You would own less than 1 billionth of this colossal, beastly company. You wouldn’t even exist as far as owners go. You’re just one person, with one share.

Now suppose that for the next 14 years the valuation of the company (PE of 14) remains the same, and that the earnings are consistent and in the form of positive cash flows. Suppose also that IBM puts 100% of its earnings into share repurchases.

In just under 2 decades, presuming you never sell your shares, you will be the sole owner of the last remaining share of IBM. Because the company reinvested all of its earnings into repurchases, and you never sold, you now own the whole entire company. And it only cost you $200 to eventually own this $200 billion behemoth.

Share Repurchases Rock!

This example is filled with exaggeration and some assumptions that do not prove true in the real world. First, earnings are never 100% cash, nor do companies see the same valuation for 14 years straight. Stock prices go up and down.

The point is, however, that most retail investors tend to look at shares only as if they are ticker symbols. Most IBM shareholders would probably be happy if, for the next X number of years, IBM shares were to rise by an average of 10% per year. Good enough, right? $200 today, $220 next year, and $242 by 2014 would keep most people happy enough not to care why or how the stock gains value.

But shares are more than just ticker symbols. Letters do not have intrinsic value – the ticker symbol IBM is worth nothing. The company that it represents is what gives it value.

Over time, the powerful compounding that happens when companies repurchase shares and increase the proportional ownership of each individual share is incredibly valuable for current owners. Unfortunately, most never see it, because few people actually care to see how much that share is actually worth as a percentage of ownership.

So, please, can we start asking for repurchases? I’d like to own the whole of the companies in my portfolio – you can have your dividends when we’re all 10% owners thanks to rapid buybacks. Until then, I’m game for more cannibalism.

{ 7 comments… read them below or add one }

Financial Uproar August 13, 2012 at 16:16

I agree, sort of. I’d love for any of the companies I own to start buying their own shares. If I think they’re cheap then I think buying these cheap shares would be a good use of excess company funds.

But companies are generally really bad at this. I’d love to see a study, but it seems like companies only buy their shares when the shares are doing well, which is the exact opposite of what they should be doing.

Reply

JT McGee August 20, 2012 at 00:37

That’s kind of the problem with open-ended repurchase agreements – much easier to do when you have a lot of cash (stock’s probably doing just fine) and easy to skip when you don’t.

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Matt August 13, 2012 at 17:21

They’re good or bad on a case by case basis.

Dozens of large cap companies I do reports on have histories of buying more shares when prices are high than when prices are low.

There are some companies that do share repurchases well, which either means consistently, or means more buying when prices are low.

A company that knows how to do share repurchases with strong valuation principles in mind can be a great thing. Chubb Corporation, for example, doubled investor’s money over the last seven years even though it had almost zero revenue growth, through a combination of dividends and aggressive share repurchases at good stock prices.

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JT McGee August 20, 2012 at 00:38

I feel like insurance companies would be one of the best at it, since a large part of their business is finding businesses to invest in at the right price. Throwing out the early 2000s, I would suspect that businesses are doing a much better job now.

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PK August 14, 2012 at 09:28

Dividends have the very real possibility of going back to unfavored status in 2013 – so you might be asking for something you’ll get for free, haha. I’m with you though – with double (triple? Sales vs. Death?) tax on dividends and tax deductible financing of debt it’s already weighted toward repurchases.

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Darwin's Money August 16, 2012 at 19:56

The other misnomer about stock buybacks is investors think they’re making out because it’s decreasing the denominator, but all the company is doing is going into the market to buy shares to replace all the options they granted to their employees each year and it’s really just a wash each year.

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101 Centavos August 19, 2012 at 17:35

Sure, some blue-chips should be following that old PF saw, “invest in yourself first”…

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