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Should Repurchases be counted in FCF/yield per share?


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In the thread on Accenture PLC, one member stated a valuation method where the expected return on investment in a share = FCF Yield + Growth.

 

I stated that if you were to do it on a per-share basis, then you have to exclude the share repurchases from the FCF Yield as they do not flow to stockholders and are reinvested in the firm in order to increase future FCF/share, and counting them in FCF Yield would be double counting as it is already reflected in the rising earnings yield.

 

However, two other posters disagreed, what's your take?

 

http://www.cornerofberkshireandfairfax.ca/forum/investment-ideas/accenture-plc-acn/msg135032/#msg135032

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I think this is relevant especially for IBM. It has strong growth per share, but it is pretty much using up all of its FCF in buybacks, so your actual FCF/s is pretty low, and if they ever reduce buybacks to increase cash flow, then growth will also come down.

 

 

http://www3.nd.edu/~scorwin/fin70610/Common%20DCF%20Errors_LeggMason.pdf

7.

Double counting.

Models should not count a dollar of value (or liability) more than once.

Unwittingly, DCF models often double count the same source of value.

Take share repurchase, for instance. Companies generating strong free cash flow often have a

record of buying back stock that is likely to continue. Analysts, recognizing both a proclivity

toward buybacks and strong cash flow, sometimes build buybacks into their models by assuming

the company uses free cash flow to shrink shares outstanding over time. This double counts

because the model values the cash flow (once) and the model uses the same cash flow to reduce

shares outstanding (twice). This error of double-counting leaves aside the analytical challenge of

judging the future stock price (the only way to properly determine how much stock a company

might buy).

Another less frequent example of double counting involves the practice of including interest

income in the cash flow calculation and adding the cash balance to corporate value. Alternatively,

some analysts subtract financing costs from cash flow and then deduct debt from corporate value

to come up with shareholder value.

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For me it depends.  If the repurchases fully go to reduce share count, then I ignore that (don't subtract it from operating cash flow).  If the repurchases are just a way of masking the dillutive effects of stock options (e.g., a lot of tech stocks) then I consider it a cost to shareholders and so I will adjust my FCF estimates as a result.

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as they do not flow to stockholders and are reinvested in the firm

 

I think you've got it backwards.  Return of capital by definition flows to shareholders, it's not a reinvestment in the firm.

 

It doesn't flow to shareholders. When a firm produces cash from operations it goes to the firm's equity, if it's used to buyback, it is an outflow that continuing shareholders do not see.

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Seems like we should just use Buffett's "owner earnings" which is the amount of cash left over after taking care of operational costs.  Everything after that is an allocation decision.

 

Now you might be tempted to keep repurchases used to keep the share count steady as part of the cash required to keep the business going, as a possibility.

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as they do not flow to stockholders and are reinvested in the firm

 

I think you've got it backwards.  Return of capital by definition flows to shareholders, it's not a reinvestment in the firm.

 

It doesn't flow to shareholders. When a firm produces cash from operations it goes to the firm's equity, if it's used to buyback, it is an outflow that continuing shareholders do not see.

 

I disagree. It's seen be whichever shareholders are directly selling the shares to the company. The remaining shareholders see no cash, but they see an increase in their % ownership of equity and cash flows and (hopefully) and increased stock price based on P/E and P/FCF multiples.

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I disagree. It's seen be whichever shareholders are directly selling the shares to the company. The remaining shareholders see no cash, but they see an increase in their % ownership of equity and cash flows and (hopefully) and increased stock price based on P/E and P/FCF multiples.

 

Yes, but the "increase in ownership" is a different component of value from "cash flow". As you noted, the remaining shareholders see an increase in cash flow, but that cash flow only came about because remaining shareholders gave up current period cash flows to do so.

 

In a DCF, you are only valuing the company based on the cash on hand + discounted future cash flows, the increase in ownership, which is true, would not be applicable.

 

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as they do not flow to stockholders and are reinvested in the firm

 

I think you've got it backwards.  Return of capital by definition flows to shareholders, it's not a reinvestment in the firm.

 

It doesn't flow to shareholders. When a firm produces cash from operations it goes to the firm's equity, if it's used to buyback, it is an outflow that continuing shareholders do not see.

 

Then you admit, it is an outflow.  To shareholders. 

 

Continuing shareholders, if they wish to "see" it, merely need to sell a few shares -- bringing their % ownership back to the prior level.

 

EDIT: Their choice of not selling any shares, thus not witnessing any cash, is similar to a shareholder who gets a dividend while enrolled in a DRIP plan.  He never sees a bump up in cash balance in his account, but he does see his % ownership of company earnings increase.  Same as with the buyback.

 

Both are merely return of capital to shareholders. 

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as they do not flow to stockholders and are reinvested in the firm

 

I think you've got it backwards.  Return of capital by definition flows to shareholders, it's not a reinvestment in the firm.

 

It doesn't flow to shareholders. When a firm produces cash from operations it goes to the firm's equity, if it's used to buyback, it is an outflow that continuing shareholders do not see.

 

Then you admit, it is an outflow.  To shareholders. 

 

Continuing shareholders, if they wish to "see" it, merely need to sell a few shares -- bringing their % ownership back to the prior level.

 

It's value given to shareholders (essentially identical to a dividend).  IF you think the shares are overvalued, and the repurchase is a bad capital allocation decision, then the shares are too expensive and you shouldn't own them anyways.  If you already own the shares, then they're overvalued and it's time to sell.

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as they do not flow to stockholders and are reinvested in the firm

 

I think you've got it backwards.  Return of capital by definition flows to shareholders, it's not a reinvestment in the firm.

 

It doesn't flow to shareholders. When a firm produces cash from operations it goes to the firm's equity, if it's used to buyback, it is an outflow that continuing shareholders do not see.

 

Then you admit, it is an outflow.  To shareholders. 

 

Continuing shareholders, if they wish to "see" it, merely need to sell a few shares -- bringing their % ownership back to the prior level.

 

It's value given to shareholders (essentially identical to a dividend).  IF you think the shares are overvalued, and the repurchase is a bad capital allocation decision, then the shares are too expensive and you shouldn't own them anyways.  If you already own the shares, then they're overvalued and it's time to sell.

 

This is the truth, amen brother.

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Then you admit, it is an outflow.  To shareholders. 

 

Continuing shareholders, if they wish to "see" it, merely need to sell a few shares -- bringing their % ownership back to the prior level.

 

EDIT: Their choice of not selling any shares, thus not witnessing any cash, is similar to a shareholder who gets a dividend while enrolled in a DRIP plan.  He never sees a bump up in cash balance in his account, but he does see his % ownership of company earnings increase.  Same as with the buyback.

 

Both are merely return of capital to shareholders.

 

No, we are discussing continuing shareholders, not those that chose to sell back to the company. If you are a continuing shareholder, then you will never see the cash, and hence it is an outflow.

 

When the firm buys back stock, you will see an increase in CF down the line due to increased ownership, but that's because you are forgoing current flows in exchange for higher future cash flows. Since you're forgoing current flows, it would be incorrect to count them as yours.

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It's value given to shareholders (essentially identical to a dividend).  IF you think the shares are overvalued, and the repurchase is a bad capital allocation decision, then the shares are too expensive and you shouldn't own them anyways.  If you already own the shares, then they're overvalued and it's time to sell.

 

I'm not talking about whether it is value, but how to account for it during valuation.

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Then you admit, it is an outflow.  To shareholders. 

 

Continuing shareholders, if they wish to "see" it, merely need to sell a few shares -- bringing their % ownership back to the prior level.

 

EDIT: Their choice of not selling any shares, thus not witnessing any cash, is similar to a shareholder who gets a dividend while enrolled in a DRIP plan.  He never sees a bump up in cash balance in his account, but he does see his % ownership of company earnings increase.  Same as with the buyback.

 

Both are merely return of capital to shareholders.

 

No, we are discussing continuing shareholders, not those that chose to sell back to the company. If you are a continuing shareholder, then you will never see the cash, and hence it is an outflow.

 

You see the cash when you sell off the incremental % ownership.

 

I could ship you a set of knives packaged in a box.  You could tell me that you didn't get any knives, all you see is a box.  I tell you to open the box.

 

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Palantir,

 

1)  Company buys back shares (packaging the payload of cash into the pool of existing shares)

2)  shareholders who want to access their share of this cash then sell offsetting share(s)  -- now they have cash.  They have taken the knives out of the box.

3)  Shareholders arguing that they didn't get any cash are just refusing to open the box of knives.  But hey, it fools the tax officials so all the best!

 

This is smarter than a regular dividend -- it achieves the same thing for the shareholders who are willing, and it launders the dividend as a capital gain.  Those shareholders who are holding their shares at perhaps a capital loss are able to get their tax laundered "dividend" as cash while at the same time writing off a capital loss on their tax return.

 

Otherwise, if you merely got a cash dividend, you would be owing dividend tax even if you held the investment for a total return loss!  Boy that really sucks don't it!!

 

And most of the time, even if you hold your shares for a gain, your cost basis isn't as low as absolute zero, so you certainly pay less in tax.

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You see the cash later, but that's because you are forgoing current cash. Otherwise you're counting cash twice.

 

You can see the cash as soon as you sell the incremental % share ownership.  I suppose "later" can asymptotically approach zero and still be defined as "later".

 

Similar to a person who reinvests his cash dividends automatically on a DRIP plan.  He too doesn't get the cash until "later".  Does that not qualify as cash returned to shareholders?

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I'm not suggesting that share buybacks do not add value, but rather how to account for those buybacks?

 

Let Adjusted Free Cash Flow = Free Cash Flow - Buybacks

 

Say you're investing in a company that makes 1M in FCF yearly, with 1M shares, and zero growth. As a shareholder, you have a claim on $1.00 every year, and this is your "Adjusted FCF/share". However, if the firm allocates 30% of that to buybacks every year, then you are exchanging current flows for higher flows in the future, and as a result, it would be double counting to consider initial Adjusted FCF/s to equal $1.00, rather it should be $0.70, and in exchange for that you can build FCF/s growth into your model.

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I stated that if you were to do it on a per-share basis

I'd say that this is the key element in the discussion. Yes, you can generate your own dividend by selling some percentage of your shares: but in that case you aren't talking about numbers on a per-share basis anymore since you are continually selling fractions of that share (in theory).

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I'm not suggesting that share buybacks do not add value, but rather how to account for those buybacks?

 

Say you're investing in a company that makes 1M in FCF yearly, and zero growth. As a shareholder, you have a claim on 1M every year, and this is your "Free Cash Flow". However, if the firm allocates 30% of that to buybacks every year, then you are exchanging current flows for higher flows in the future, and as a result, it would be double counting to consider initial Free cash flow to equal 1M, rather it should be 700k, and in exchange for that you can build FCF growth into your model.

 

That makes sense.

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However, if the firm allocates 30% of that to buybacks every year, then you are exchanging current flows for higher flows in the future, and as a result, it would be double counting to consider initial Free cash flow to equal 1M, rather it should be 700k, and in exchange for that you can build FCF growth into your model.

 

That gets a little weird if the firm were to stop buying back shares.  You are going to have free cash flow jump from 700k to 1m in a single year, even though FCF isn't growing.  That might sound like I'm bickering over semantics, but if I was collaborating with you on a software project I would mention that your choice of naming for variables makes the code difficult for others to understand/maintain. 

 

It might compile and run just fine though, no argument there.

 

Let me ask you a question though.  How would you go about it if you were instead looking at a company that returned cash to shareholders only through dividends.  Would you ignore the dividend yield, or would you instead count the dividend and redefine "free cash flow"?

 

Maybe there is another way without redefining what free cash flow is -- that's all I'm trying to say.  I'm not saying that your end result would be wrong.

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I'll throw my hat in the ring:

 

I ignore buybacks in "modelling".

 

I just calculate FCF or Owner Earnings or whatever you want to call it.

 

What the company does with that cash afterwards I treat as a different story.

 

So I separate the analysis into two sections: what the business operations generate, and what management does with those proceeds afterwards.

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