Should Repurchases be counted in FCF/yield per share?

[vinod1]

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

 

Palantir,

 

You got it right. If you look at the dividend discount model, which is the simplest case of the discounted cash flow model, this becomes very obvious.

 

In DDM, value of a share of stock = Dividend next Year/(Cost of Equity - Growth rate of Dividends forever)

 

Growth rate of Dividend = (1 - Payout Ratio) x Return on Equity

 

To account for share buybacks, you would adjust the Payout Ratio and hence the Dividend next year. This automatically adjusts the growth rate down. Just as you noted, growth rate is adjusted down while the dividend for next year is adjusted up. It does not make sense to assume that both dividends go up and growth rate goes up.

 

Big Boss of valuation, Damodaran, has written about this quite a bit so you are on firm ground.

 

Vinod

[mcliu]

The reason being, I think the DCF model has some necessarily simplifying assumptions, eg, that cash flows are paid straight to investors, or that there is no distinction between the investor and the "firm".

 

If the firm just generated 1M in FCF and did nothing with it, it would form a part of the firm's cash account and be an element of value for the company, however if it was used to repurchase shares, it would certainly create value for shareholders, but the way I see it, that value would be counted in your future projections of per share FCF.

 

Only if the company is repurchasing at prices below fair value. You should think of it as a dividend.

[JSArbitrage]

The reason being, I think the DCF model has some necessarily simplifying assumptions, eg, that cash flows are paid straight to investors, or that there is no distinction between the investor and the "firm".

 

If the firm just generated 1M in FCF and did nothing with it, it would form a part of the firm's cash account and be an element of value for the company, however if it was used to repurchase shares, it would certainly create value for shareholders, but the way I see it, that value would be counted in your future projections of per share FCF.

 

I think what I am trying to communicate is the following: economically, a firm that puts $1M in FCF in the bank and a firm that uses FCF to buy $1M in shares are of equal value assuming the shares are rationally priced.  So I am confused when you say the buy-back "creates value" for the shareholder.  It doesn't create any more than putting it in the bank.  Do you agree or disagree with this?

 

 

[ERICOPOLY]

The reason being, I think the DCF model has some necessarily simplifying assumptions, eg, that cash flows are paid straight to investors, or that there is no distinction between the investor and the "firm".

 

If the firm just generated 1M in FCF and did nothing with it, it would form a part of the firm's cash account and be an element of value for the company, however if it was used to repurchase shares, it would certainly create value for shareholders, but the way I see it, that value would be counted in your future projections of per share FCF.

 

Only if the company is repurchasing at prices below fair value. You should think of it as a dividend.

 

Why is the stock valuation of any relevancy?  It's the total amount of cash returned to investors that matters.

 

Proof:  each shareholder can sell an offsetting amount of shares at any price that the company buys it from them.  Like a tender offer for example.  The company can offer to buy out each investor's fractional ownership at a billion times IV.  It won't matter, they'll each get exactly the same amount of cash as they would have received if instead a cash dividend had been paid.  After the transaction, they will each own exactly the same % of the business as beforehand.  Cash is the same as dividend.  Ownership is the same as with the dividend.  The only key here is that they need to do their part and sell some shares to offset the buyback.

 

This whole thing about high priced buybacks destroying value is a hoax -- the shareholders are the ones destroying value by holding their shares instead of selling them.  They're the ones making the bad capital allocation decisions, but ain't it convenient to blame management?  Management is at least helping them with tax efficiency.

[JBird]

This whole thing about high priced buybacks destroying value is a hoax -- the shareholders are the ones destroying value by holding their shares instead of selling them.  They're the ones making the bad capital allocation decisions, but ain't it convenient to blame management?  Management is at least helping them with tax efficiency.

 

This is a really interesting point. I agree it's rational for the shareholder to get out when his shares are over-priced. However, the shareholders as a group cannot get out. Therefore, I think it makes sense to look at the attractiveness of buybacks from the perspective of the perpetual shareholder-- after all, that's the entity management is working for.

 

Let's take the example of an investment holding company doing a buyback. The company has 100 shares. It has $1,000 cash, and no other assets. It has no liabilities. Leaving tax implications aside, the valuation for this company is pretty straight-forward; it's worth $10 a share.

 

If the company repurchases 10 shares at $20 per-share, what is the effect? Net assets are now $800, and there are 90 shares outstanding. Per-share value went down to $8.88

 

Frankly, I want to be the shareholder cashing out at $20 per-share. But if I'm the CEO and my job is to increase per-share value for the perpetual shareholder, this buyback is a disaster.

[Palantir]

I think what I am trying to communicate is the following: economically, a firm that puts $1M in FCF in the bank and a firm that uses FCF to buy $1M in shares are of equal value assuming the shares are rationally priced.  So I am confused when you say the buy-back "creates value" for the shareholder.  It doesn't create any more than putting it in the bank.  Do you agree or disagree with this?

 

I disagree, from the POV of the continuing shareholder, on a per share basis, a buyback would yield a different value.

[Palantir]

Why is the stock valuation of any relevancy? It's the total amount of cash returned to investors that matters.

Proof:  each shareholder can sell an offsetting amount of shares at any price that the company buys it from them.  Like a tender offer for example.  The company can offer to buy out each investor's fractional ownership at a billion times IV.  It won't matter, they'll each get exactly the same amount of cash as they would have received if instead a cash dividend had been paid.  After the transaction, they will each own exactly the same % of the business as beforehand.  Cash is the same as dividend.  Ownership is the same as with the dividend.  The only key here is that they need to do their part and sell some shares to offset the buyback.

 

Mcliu was arguing from the POV of the continuing shareholder. If other shareholders sell out at say, an infinite multiple, it won't create value for the shareholder who continues to hold.

[mcliu]

I think what I am trying to communicate is the following: economically, a firm that puts $1M in FCF in the bank and a firm that uses FCF to buy $1M in shares are of equal value assuming the shares are rationally priced.  So I am confused when you say the buy-back "creates value" for the shareholder.  It doesn't create any more than putting it in the bank.  Do you agree or disagree with this?

 

I disagree, from the POV of the continuing shareholder, on a per share basis, a buyback would yield a different value.

 

Only if the buy-back is done below the fair value of the company.

 

I think if you build a DCF, all of this should be pretty evident.

[Munger_Disciple]

Palantir,

 

Buyback can be thought of as a tax-efficient way to pay dividends to shareholders. If the stock buyback is done below IV, then you are increasing the per share IV of the remaining shares. If taxes were zero, you can do your own buyback if the company paid only dividends.

[ERICOPOLY]

However, the shareholders as a group cannot get out.

 

They can get out if there is a buyer -- and the company is that buyer.  Therefore, there must be a way for them to get out of the shares that  the company is repurchasing.

 

There must be some way that a company can issue a reverse rights offering -- in other words, a right to sell at a certain price.

 

Say you have 100,000 shares and the company issues you the rights to sell 1,000 shares at a given price.

 

There you go, it's a tax-efficient way of returning capital to shareholders.  Every shareholder can participate.  Management should prefer this method of buying back shares  because the shareholders can no longer blame management for the capital allocation decision -- it will be plainly obvious that it was their choice not to sell to the company, the allocation decision is squarely on the shoulders of the shareholder.

[constructive]

I voted no - as described your example is double counting.

 

But I think repurchases should be included in FCF yield. Repurchasing shares is one of the more optional or "free" things a company can do with cash. The problem of double counting only occurs when you add another metric which also includes repurchases.

 

I think the phrasing of the question contributes to the lack of consensus on the poll topic.

[JBird]

However, the shareholders as a group cannot get out.

 

They can get out if there is a buyer -- and the company is that buyer.  Therefore, there must be a way for them to get out of the shares that  the company is repurchasing.

 

There must be some way that a company can issue a reverse rights offering -- in other words, a right to sell at a certain price.

 

Say you have 100,000 shares and the company issues you the rights to sell 1,000 shares at a given price.

 

There you go, it's a tax-efficient way of returning capital to shareholders.  Every shareholder can participate.  Management should prefer this method of buying back shares  because the shareholders can no longer blame management for the capital allocation decision -- it will be plainly obvious that it was their choice not to sell to the company, the allocation decision is squarely on the shoulders of the shareholder.

 

To be sure, a shareholder cashing out via company repurchase is being bought out by the remaining shareholders. You can follow this process to its logical end, where just 1 share remains. But the final shareholder can't cash himself out at an inflated price.

 

To update my previous example: 100 shares and $1,000 in net assets. IV of $10 per-share. 99 shares are repurchased for $10.10. After the repurchase, 1 share remains and its value is $0.1. The company can't repurchase this share, right? That's why I'm saying that as a group the shareholders can't get out. If the company can repurchase this final share, it certainly can't do it at a price above 10 cents.

 

Contrast that repurchase price to the "bargain" repurchase price of $5 per-share. When 99 shares are repurchased, per-share value rises from $10 to $505.

 

All that said, I'm willing to be wrong here.

[racemize]

I voted no - as described your example is double counting.

 

But I think repurchases should be included in FCF yield. Repurchasing shares is one of the more optional or "free" things a company can do with cash. The problem of double counting only occurs when you add another metric which also includes repurchases.

 

I think the phrasing of the question contributes to the lack of consensus on the poll topic.

 

absolutely agree, although I think I voted yes.

[ERICOPOLY]

However, the shareholders as a group cannot get out.

 

They can get out if there is a buyer -- and the company is that buyer.  Therefore, there must be a way for them to get out of the shares that  the company is repurchasing.

 

There must be some way that a company can issue a reverse rights offering -- in other words, a right to sell at a certain price.

 

Say you have 100,000 shares and the company issues you the rights to sell 1,000 shares at a given price.

 

There you go, it's a tax-efficient way of returning capital to shareholders.  Every shareholder can participate.  Management should prefer this method of buying back shares  because the shareholders can no longer blame management for the capital allocation decision -- it will be plainly obvious that it was their choice not to sell to the company, the allocation decision is squarely on the shoulders of the shareholder.

 

To be sure, a shareholder cashing out via company repurchase is being bought out by the remaining shareholders. You can follow this process to its logical end, where just 1 share remains. But the final shareholder can't cash himself out at an inflated price.

 

To update my previous example: 100 shares and $1,000 in net assets. IV of $10 per-share. 99 shares are repurchased for $10.10. After the repurchase, 1 share remains and its value is $0.1. The company can't repurchase this share, right? That's why I'm saying that as a group the shareholders can't get out. If the company can repurchase this final share, it certainly can't do it at a price above 10 cents.

 

Contrast that repurchase price to the "bargain" repurchase price of $5 per-share. When 99 shares are repurchased, per-share value rises from $10 to $505.

 

All that said, I'm willing to be wrong here.

 

I'm glad you're willing to be wrong  :D

 

Kidding aside,

 

My example was for an inverted rights offering.  You see, the company gives each shareholder the right to sell 1% of shares back to the company.

 

So you're wrong (and willing to be) if you were disagreeing with me -- the person isn't cashing out at the expense of remaining shareholders, he is merely cashing out at his own expense.  In other words, the shares he cashes in are purchased with his pro-rata share of the company cash.

 

Just like when he gets a 1% dividend -- it's not paid at the expense of other shareholders is it?  No, it's paid at his own expense.  Just like with the inverted rights offering, it's just his pro-rata share of what the company is returning in cash.

 

The reason why I introduced this concept of inverse rights offering was to totally eliminate the argument that shareholders are being cashed out at the expense of existing shareholders.

[ERICOPOLY]

People who choose not to exercise their right to tender shares at X price indicate their intentions by a certain date, after which time the company offers that tender price 'X' to the open market.  Therefore, the company will be able to distribute all the cash it intends to distribute.  Those shareholders that wish to take their pro-rata share of cash will tender their shares at that X price.  Those that don't tender their shares made a conscious decision to reinvest their share of the cash at that X price -- forever shall they hold their peace.

 

[JBird]

I do agree that your idea works. But to my knowledge, companies aren't doing inverted offerings. So my example was meant to illustrate what happens without such a thing.

[ERICOPOLY]

I do agree that your idea works. But to my knowledge, companies aren't doing inverted offerings. So my example was meant to illustrate what happens without such a thing.

 

Let's take it without the inverted offering.  Let's say, for example, that I'm running Coca Cola (KO) as dictator of the company.  I simply convey that I'm going to cut the dividend to zero and instead purchase 28 cents per share of stock every quarter, trying as best I can to make an even-sized purchase each and every day.

 

The shareholder merely needs to make 28 cents worth of sales, each and every quarter.

 

Voila!

 

The prices each shareholder sells at might not be exactly the same (sometimes higher, sometimes lower), but over time that will completely wash out.  After all, we're talking about long-term shareholders, right?

[JBird]

The shareholder merely needs to make 28 cents worth of sales, each and every quarter.

 

I don't follow here.

[ERICOPOLY]

The shareholder merely needs to make 28 cents worth of sales, each and every quarter.

 

I don't follow here.

 

Well, the shareholder is no longer getting a 28 cent per quarter cash dividend any longer (it was cut to zero).  Let's say the shareholder has 100,000 shares.  In the old days, he would get $28,000 of cash dividend each quarter.  Under my regime, the company will be using that very same $28,000 (28 cent per share per quarter) to repurchase shares.

 

Now (under my regime), he just sells shares each quarter amounting to $28,000 cash proceeds.  He might not even owe any tax on this (depends on his cost basis).  Potentially he sold for a capital loss and can actually take the $28,000 distribution completely tax free, as well as reducing his capital gains tax bill from other sales.

 

Compared to the world where he's automatically paying tax on $28,000 of dividend, that's a huge leap forward for mankind.

 

And what about the little shareholder who only owns 1 share?  Well, tell me this -- how in the hell is he going to reinvest a 28 cent cash dividend when the brokerage charges him $8 per transaction?  He's better off just having it reinvested back into the shares because an investor that small suffers too much expense drag from commissions.

 

And when the share count gets too low from years of constant share repurchases?  Just split the stock.

 

[ERICOPOLY]

But if you were speaking on behalf of Berkshire shareholders, well then you very well may be very resistant to my scheme.

 

Berkshire pays 35% tax rate on capital gains and 14.5% tax rate on dividends.

 

So, where do you think their spokesperson stands on this issue?  Eh?

[krazeenyc]

The shareholder merely needs to make 28 cents worth of sales, each and every quarter.

 

I don't follow here.

 

Well, the shareholder is no longer getting a 28 cent per quarter cash dividend any longer (it was cut to zero).  Let's say the shareholder has 100,000 shares.  In the old days, he would get $28,000 of cash dividend each quarter.  Under my regime, the company will be using that very same $28,000 (28 cent per share per quarter) to repurchase shares.

 

Now (under my regime), he just sells shares each quarter amounting to $28,000 cash proceeds.  He might not even owe any tax on this (depends on his cost basis).  Potentially he sold for a capital loss and can actually take the $28,000 distribution completely tax free, as well as reducing his capital gains tax bill from other sales.

 

Compared to the world where he's automatically paying tax on $28,000 of dividend, that's a huge leap forward for mankind.

 

And what about the little shareholder who only owns 1 share?  Well, tell me this -- how in the hell is he going to reinvest a 28 cent cash dividend when the brokerage charges him $8 per transaction?  He's better off just having it reinvested back into the shares because an investor that small suffers too much expense drag from commissions.

 

And when the share count gets too low from years of constant share repurchases?  Just split the stock.

 

Eric, in theory what you say makes a lot of sense. However, the real life application of your theory doesn't work for quite a few reasons.

 

1) There are individuals and funds that want dividends. By offering a nice steady growing dividend you broaden your investor base (that's good for your share price).

 

2) Companies often disproportionately buyback shares from insiders in negotiated transactions.

 

3) For some old guy who bought KO in 1950 or whatever he'd be crushed on cap gains taxes, whereas he can pay 0-15% in dividend taxes.

 

4) If an older gentleman/lady/couple etc owns $1,000,000 in stocks that yield 5% on avg, they can get $50k a year in yearly income (at low taxes) and no transactional costs (I think this is part of why point 1 exists).

[ERICOPOLY]

3) For some old guy who bought KO in 1950 or whatever he'd be crushed on cap gains taxes, whereas he can pay 0-15% in dividend taxes.

 

In the USA, the qualified dividend rate is the same as the long term cap gains rate.  All of my comments pertain to the USA if there was any confusion.  Any place where your cap gains rate is higher than your dividend rate (like Warren Buffett at Berkshire) you can take the other side.

 

So that guy is no worse off if he chooses to sell tiny amounts in lieu of a dividend.  And he's better off if he wants it reinvested (tax free reinvestment).  And being an old guy, his heirs probably want that as well given that it will all be stepped-up in cost basis upon his death.  They can either sell his shares (getting all those reinvested buybacks tax-free), or they can choose to keep the shares and start selling pieces to offset buybacks -- with the cap gains paid at the new stepped-up cost basis.

[krazeenyc]

3) For some old guy who bought KO in 1950 or whatever he'd be crushed on cap gains taxes, whereas he can pay 0-15% in dividend taxes.

 

In the USA, the qualified dividend rate is the same as the long term cap gains rate.  All of my comments pertain to the USA if there was any confusion.  Any place where your cap gains rate is higher than your dividend rate (like Warren Buffett at Berkshire) you can take the other side.

 

So that guy is no worse off if he chooses to sell tiny amounts in lieu of a dividend.  And he's better off if he wants it reinvested (tax free reinvestment).  And being an old guy, his heirs probably want that as well given that it will all be stepped-up in cost basis upon his death.  They can either sell his shares (getting all those reinvested buybacks tax-free), or they can choose to keep the shares and start selling pieces to offset buybacks -- with the cap gains paid at the new stepped-up cost basis.

 

I guess that's right, but there is no cost to get the dividends whereas he has to pay commissions to sell bit by bit. I think ultimately the biggest reason to pay the dividends is to broaden the investor base.

[ERICOPOLY]

3) For some old guy who bought KO in 1950 or whatever he'd be crushed on cap gains taxes, whereas he can pay 0-15% in dividend taxes.

 

In the USA, the qualified dividend rate is the same as the long term cap gains rate.  All of my comments pertain to the USA if there was any confusion.  Any place where your cap gains rate is higher than your dividend rate (like Warren Buffett at Berkshire) you can take the other side.

 

So that guy is no worse off if he chooses to sell tiny amounts in lieu of a dividend.  And he's better off if he wants it reinvested (tax free reinvestment).  And being an old guy, his heirs probably want that as well given that it will all be stepped-up in cost basis upon his death.  They can either sell his shares (getting all those reinvested buybacks tax-free), or they can choose to keep the shares and start selling pieces to offset buybacks -- with the cap gains paid at the new stepped-up cost basis.

 

I guess that's right, but there is no cost to get the dividends whereas he has to pay commissions to sell bit by bit. I think ultimately the biggest reason to pay the dividends is to broaden the investor base.

 

What is the advantage of broadening the investor base?  You are certainly not the first person I've heard talk about that, but it's never something that I've ever quite understood why it's so important..

 

There are some admired companies like MKL and Berkshire that have a great shareholder base -- but they don't pay dividends.  What would improve if they attracted dividend investors?  Alright, if somebody says it would boost the share price, I could always say that it would only help the investors who are cashing out and not the ones who are sticking around.

 

Let's say I am going to be a long term investor -- is it important that I have a broad base of fellow shareholders?  Not to me personally.  What matters more to me is when I get more in dividends than I spend, so I have to reinvest a good portion on an after-tax basis.  Then I've only got 67 cents on the dollar left to reinvest.  And that's really destructive to my buying power.

 

A dollar of dividends comes from a blue chip stock, but I only keep 67 cents after paying tax.  Where the heck am I going to find blue chip stocks priced at less than 67 cents on the dollar???  That's why dividends are value destructive.  I basically get payed only 67 cents and then wind up investing it back into the stock which is priced near a full dollar (most blue chips are not heavily discounted).

 

The dividend rate for me is up to about 33% now -- 20% Federal, then 13% California, then the extra Obamacare/Medicare (or some sort of new health related) investment surtax crap.  That takes my $1 of dividend down to only 67 cents.  That's practically 2/3.  It's just as value destructive as paying 150% of fair value in a stock buyback!  So when people say (like it's some religion) that buybacks only make sense under fair value, I think not!  There's a lot of room above fair value before they are more value destructive than dividends.

 

Additionally, if I'm going to be losing 33% of value, I'd rather it go to fellow investors than the government tax collector.

 

[JBird]

After working through a few examples I must say you've got me here. I now agree that if your aim is to return capital to shareholders you're always better off doing it through repurchases than dividends (given the current tax code), regardless of the buyback price.

 

Given my earlier example I'm still inclined to say that buybacks at various prices affect the per-share value. Do you agree? Or do you want to blow up another one of my paradigms?

 

I guess that's right, but there is no cost to get the dividends whereas he has to pay commissions to sell bit by bit. I think ultimately the biggest reason to pay the dividends is to broaden the investor base.

 

What's the advantage of having a broad investor base?