SKARBECK: Firms that buy back shares are often using cash wisely

Recently, the investment community has criticized a number of U.S. companies for using corporate cash to buy back stock. These critics have suggested that managements who buy back stock are engaging in “financial engineering” to artificially boost earnings. They contend stock buybacks are shortsighted and that, instead, companies should use their cash to make acquisitions or reinvest in the business to fund growth.

The basis for this criticism is invalid—if the company is buying back its stock at undervalued prices. Savvy long-term investors understand that, when a company repurchases its stock at prices below intrinsic value, their ownership of the business increases.

For example, consider a company that has 100 shares outstanding and you own 5 percent of the business, or five shares. The company announces a program to buy back 10 percent of its outstanding shares. Since you are a long-term investor and recognize the shares are worth more than the current price, you continue to hold onto your interest in the company.

Over the next year or so, the company enters orders to buy its stock on the open market, just like any other investor would. When the buyback is completed, the company “retires” the 10 shares it bought and now has 90 shares outstanding. Even though you took no action, your ownership in the company increases to 5.56 percent.

Another benefit for long-term investors is that earnings per share increase. If the company earned $100 when it had 100 shares outstanding, producing $1 per share in earnings, $100 in earnings on 90 shares produces earnings of $1.11 per share. A shareholder-oriented management likely would continue to buy back even more shares if the stock market continued to undervalue its stock.

Now, if management can use its cash to fund smart acquisitions at attractive prices and can reinvest cash within the business and generate high returns on capital, these opportunities should be pursued. However, often, managements overpay for acquisitions or squander cash on projects that fail to pay off. Managers who are driven to “grow the empire” for the sake of running a larger business are susceptible to mistakes that lead to losses and write-downs of assets acquired at overvalued prices.

In 2010, Apple’s Steve Jobs called Warren Buffett looking for advice on what to do with all the cash Apple had filling its coffers. Buffett told him there are only four things you can do with cash: stock buybacks, dividends, acquisitions, or sit with it.

When Buffett asked him if he thought Apple stock was undervalued, Jobs responded yes. As a result, Buffett advised that the best thing Jobs could do with Apple’s cash was to buy in shares. At the time, Apple stock was trading around $30 per share. Jobs never initiated a buyback program. However, under CEO Tim Cook, Apple has bought back a significant amount of stock in recent years.

The most important decisions managements make involve the intelligent allocation of free cash—whether for stock buybacks, dividends or acquisitions. The success of these decisions is determined by the price that is paid relative to the long-term value received by the owners of the business—the shareholders.•

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Skarbeck is managing partner of Indianapolis-based Aldebaran Capital LLC, a money management firm. His column appears every other week. Views expressed are his own. He can be reached at 818-7827 or ken@aldebarancapital.com.