Do Huge Stock Buybacks Distort P/E Ratios?
Interesting intellectual argument given the prevalence of stock buybacks these days. Do buybacks distort P/E ratios, assuming all else held constant (i.e. investor expectations, etc.)?
My sense is if a company uses cash on hand to buy back 50% of shares outstanding, then their EPS doubles while their share price is unchanged. Hence their P/E ratio roughly halves. This gives some investors the sense that a company is trading "cheap," when actually the P/E is being distorted by a share buyback. Again this is assuming all else held constant.
Curious to see what the monkeys think.
It’s more likely for the stock price to go up and the multiple to be unchanged assuming the company didn’t lever up the balance sheet for the share repo
Why is it more likely for the stock price to go up and the P/E to stay unchanged?
Again I am assuming all else held constant. I can see what you're saying being the case if the buyback fundamentally changes investors expectations (ohh the company is buying shares so shares must be cheap). But under ceteris paribus conditions, I would think the stock price is unchanged since nothing has changed about the underlying business...
Nothing has changed about the business but EPS and FCF/share just doubled if you cut the share count in half. Why would each dollar of earnings/FCF be worth less (which is what you are implying by saying the stock price would be unchanged)? In an “all else equal” scenario, the stock would double.
They just burned a fuck-ton of cash off the balance sheet to pay for the buyback. By all else held constant, I don't mean they generated money out of thin air to pay for the buyback.
Source: McKinsey - The Value of Share Buybacks
Yes, I get the argument…buybacks in theory don’t change the EV, so the change in net debt comes out of equity and when you divide by the lower share count you get the same stock price. However, investors look closely at per-share metrics, especially EPS and FCF/share. The stock wouldn’t double, but it would still go up because the future FCF of the business that my share represents is now higher. I am also assuming that 1) the business earns its cost of capital, 2) the company isn’t in structural decline, 3) the stock isn’t overvalued to begin with, and 4) the buyback doesn’t materially change the balance sheet risk (in your example it easily could).
The increase in FCF/share is exactly offset by the decline in shareholder equity due to the burned cash, which should leave the share price unchanged.
The only real effect that the decrease in share count gets you is that future changes to the business are concentrated to the remaining shareholders. If the company performance exceeds ex ante expectations, remaining shareholders will do much better than pre-buyback. The opposite is true as well if the company does poorly.
I believe this is also why companies try to repurchase shares when the "stock is cheap"... to amplify future returns to remaining shareholders if the company does indeed beat market expectations in the future. That said, it's pretty laughable how often mgmt teams end up mis-timing the market and buying shares when they are expensive...
You’re right in theory, but in practice cash held on the balance sheets is usually valued with a sizable discount, due to uncertainty regarding good/bad capital allocation. I am going from memory, but I think it was something like 30-50% discount on average.
This would suggest that cash being return would generate value.
This is a bit confusing and it helps to be more specific. Here are my 2 cents.
When company buys back shares, any trailing metric of earnings or FCF used in calculating a trailing P/E or P/FCF ratio cannot change - it's already happened.
Therefore the trailing FCF/share, EPS can only go up proforma for the share buybacks.
However, investors will really care more about forward or future FCF/share, EPS because they can't experience past earnings or FCF power.
The issue is that if there was a reason for the cash balance to exist or a large portion of earnings had to be reinvested, you'd implicitly be lowering future revenue and therefore earnings and FCF growth by returning to shareholders. Obviously this is very abstract so one way immediate way to check is to consider if it's more commercially viable to reinvest the earnings for a year or return it for a year.
The way to check for 1 year is to consider if the marginal forward return on equity is sufficient to hurdle the current market-cap implied cost of equity. You'll have to make an assumption that forward ROE = trailing ROE (which may not hold in a competitive, changing environment) and the cost of equity would either come from an adjusted CAPM model or an adjusted earnings yield. If the cost of equity is higher than forward ROE you'd go forth with the buyback until the marginal cost of equity is higher.
So then the question is what happens to the share price? It really depends. Share price could go up because some view it purely qualitative (signaling effect, better governance of excess cash build, etc.) whereas some may actually be doing the ROE vs. cost of equity math. Ultimately you will have to realize that share price is not just EPS/share times P/E ratio for every single market participant (keep in mind there are substantial algorithms, technical traders, speculators, etc.) as it would be in an academic setting. Likewise, the proforma P/E ratio is not a hardcoded input but an output - you cannot say that it necessarily goes down, because it really just reflects the proforma share price which is a blackbox and unknown.
In reality you’re right. The actual value created by the buyback is determined whether they actually bought back the shares when they were underpriced or not. Your points that equity value should be penalized 1-for-1 for the cash outflow - only true if 1) the company overlevers and diverts cash from otherwise productive uses or 2) they bought back the stock for too high a price
This actually does happen - look at American which levered up irresponsibly to do an aggressive buyback 2015-2018. They ended up with a dangerous amount of debt and the p/e multiple did in fact suffer relative to peers.
If you have excess cash - you can reinvest, m&a or return capital (buy back share or dividend). Buyback is more tax efficient. CEOs should always do the highest roic of these options. However investors tend to be bullish and like the ‘symbolism’ and upward buying pressure of buybacks, ceos tend to elect to keep reinvesting and doing m&a to build empires even when it’s value destructive.
Like all things - ‘it depends’. Also, in a low/0 interest rate driven bull market, it was even more well received.
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Bump - my hazy memory of Mogdiliani taught back at school would say you can’t create value from share buybacks but would price/share remain the same in a Mogdiliana world?
For most people, their intuition goes against modigliani-miller, which is why I thought it would be an interesting question to ask.
Modigliani -Miller goes against most peoples intuition because it's not intended to be a true reflection of how the world works. Even when the theory was first published, the key takeaway was that because everyone knows the conclusion is wrong, the assumptions used must be the variables that cause capital structure to impact value.
(i.e. Modigliani -Miller assumes no taxes - and the interest tax shield is one of the reasons why having debt in a capital structure creates value)
not sure what is distortionary about about that. theoretically, the before P/E multiple accounts for the excess cash balance so it should be lower after the cash is distributed.
So what's your takeaway?
I think all things constant buybacks increase share price, but as things never stay constant, impossible to verify.
As people said cash is valued at discount as it is useless/underproductive. I believe that returning unused cash to shareholder increases share price on the long run.
Buying back shares means the company invests in itself, it leverages the current pipeline of projects. The same output of those projects -> future cash flows will be divided by less shares, so shares value should increase
I agree the company should not put herself at risk in case there is a downturn, but as long as there is a decent cash buffer, all surplus cash should be returned, either by buybacks or other ways
Buybacks lower P/E for the reason OP said. But it's not distortive or manipulative because the company is also now riskier as a result of the buyback. It used cash, an in many cases took on debt as well, to fund the buyback. Net debt is up and P/E is down.
While I don't think there's anything wrong with that, this is one of a few reasons EV/EBITDA is popular. It won't be affected by buybacks or other capital structure decisions.
The one way buybacks are manipulative is when the CEO is paid off an EPS target and uses the buyback to hit EPS.
Depends on the market - in England you don’t have to cancel the shares and can keep them in Treasury. But I’d say it’s otherwise reflected in the implied risk of the name
Hey man, in theory, you’re absolutely right. EV multiple is unchanged, net debt rises by the amount used to fund the buyback so market cap should fall yadda yadda a buyback should not change the share price.
In reality (probably due to historically low costs of capital, cash in balance sheet being valued at a discount and low default rates), investors see businesses as a going concern and therefore do not consider them from an EV/EBITDA starting point but instead from a P/E multiple starting point (because as an equity investor that’s what you’re actually buying). There’s good evidence for this btw. So when you do a buyback you normally end up keeping the P/E ratio constant (or mostly constant as long as you don’t use excessive leverage) and so yes from a corporate finance point of view you create value from nothing. You can even see that when companies announce extraordinary buybacks the share price will normally get a bit of a bump.
I always interpreted the bump in share price for buyback announcements simply as signals from management that the stock is trading too cheap and some investors believe the signal and buy-in to it which increases the stock price. This obviously confuses people as to the underlying fundamental forces - they start to believe that buybacks increase share price and keep P/E constant which is essentially creating money out of nothing like you said. However, it's not really the buyback doing the work, it's mgmt's signalling that the share price is undervalued.
Not sure what you mean by "distort". Using your example, most of us would see the pile of cash and then adjust the PE on an ex-cash basis. So I don't think that anyone is necessarily misled by the higher vs. lower PE.
exactly
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