The Math, Science and Hokum behind Equity Share Buybacks

The Backdrop

All valuation endeavours invariably pursue a singular purpose, the pinning down of the ever-elusive chimera, the 'Intrinsic Value' of an asset i.e. the value of an asset given the complete understanding of all investment characteristics. The analyst's understanding will, however, usually fall short such that her view of value would only reflect her estimation of the true value of the asset. Subsequent financial decisions then hinge not only on the quantum of the perceived mispricing but also on the time horizon within which price conversion would take place and the presence of market/corporate events to act as catalysts stimulating such convergence.

A share buyback tender announcement is one such corporate event that implores the market and investors to revise expectations regarding the company's equity. This essentially makes a share buyback event a signalling exercise to solicit a favourable response from the market.

The Potential Motivations

• Signal: "Market is undervaluing our shares!" - Share prices in equity markets, which are incessantly nudged by several factors, far beyond company fundamentals could occasionally, in the management's estimation, deviate far below the intrinsic value. By offering to buyback some of the outstanding shares, the management can assuredly signal conviction in the company's future prospects and actuate markets to favourably adjust company-specific value drivers. Such a claim warrants close examination of the value drivers and attribution of the undervaluation.

• Returning Cash to rightful owners - Shareholders: To some, the fact that Corporate executives, who are essentially the fiduciaries of shareholders' funds, periodically return money to shareholders does not warrant any raised eyebrows, this could nevertheless be an indication that the management may be out of value-generating ideas, i.e. the management potentially feels the company has used up most of the industry-imputed growth runway and not many opportunities exist to invest the excess cash within the business at rates above the cost of capital (Ke).
• Manipulating EPS: Managements periodically issue reports and hold press conferences in which they provide guidance on future earnings. In case the management fails to generate expected EPS growth by expanding or optimizing operations, the same can be achieved by resorting to some nifty financial engineering. A share buyback instantly reduces the denominator in EPS i.e. number of outstanding shares and artificially jacks up the EPS.
• Increasing Financial Leverage: Buybacks are a potent way to increase the financial leverage of the company. With outstanding equity units coming down, the Debt/Eq ratio surges. This is often favourably construed as a signal of high management confidence in future cashflows. Readiness to adopt a higher contractual obligation for fixed interest payments not only stands as a testimony to the management's conviction but also leaves lesser cash in the hands of the management to make discretionary spending calls with it, thus curtailing Agency costs.
• Management's Shenanigans: Senior management often has EPS as one of the prime metrics deciding their performance-linked-pay. A higher EPS, albeit artificially generated, entitles executives to increased take-home salaries. Buybacks also have far-reaching impacts on the Balance Sheets of companies - cash to the extent of the amount expended on the buyback is reduced from the asset side and an equivalent amount disappears from shareholders' equity on the liabilities side. This sly manoeuvre could then result in significant improvements in a whole host of financial and operating efficiency ratios: ROE, RoIC, ROA, etc.

The Evolutionary Biology Analogue

Imagining Share Buybacks as a 'Zahavian Signal' from companies:

Amotz Zahavi, an Israeli biologist observed a fascinating set of traits among species across biological classes - the act of sending 'Signals'.

Exhibit A: When a herd of gazelles spot a predator lurking close by, instead of sprinting away (which has a high metabolic cost) and creating more distance between them and the predator, many gazelles surprisingly, make themselves conspicuously visible in front of the predator and exhibit a behaviour called 'stotting'. This, however, is not a case of injudicious over-confidence, but rather a testament and a signal to the predator of their athleticism and conviction in their ability to outrun the predator.

The signal is honest, yet costly - if the predator calls the bluff and goes after it anyway, the gazelle would be at a much higher risk of death, but if the predator believes the signal, the gazelle is spared from incurring the high metabolic cost that sprinting entails.

A share buyback offer is in many ways like a Zahavian signal. It is a costly commitment from the management for the company's equity. It conveys management’s conviction that expectations about consensus value drivers are too low. The signal is costly - if the market perceives the buyback negatively, it would adversely impact prior growth expectations about the company and reflect the same in share prices. The signal is also honest since continuing shareholders effectively buy up the interests held by sellers (ones who do not buy into the optimism of the management) at the current market imputed price, thus increasing their 'Skin in the Game'.

The Math

Rate of Return from Buyback for continuing shareholders: The value of buyback for continuing shareholders is a positive function of undervaluation by the market.

Return on Buyback = Ke * (FV / CMP)

For instance, imagine a company with a cost of equity of 8%, with shares currently trading at 280/- and management prescribed fair value of 370/-.

A buyback essentially entails the continuing shareholders buying up equity from other holders with the expectation of equity Fair Value being realized in future. Return on buyback thus is directly related to the quantum of undervaluation. Here, the return from buyback will be = 8%*(370/280) = 10.57%.

The Takeaways

1. The current Market Price of the company stock must be significantly below the realizable Fair Value of the stock.
2. The company should be in a position wherein better investment opportunities do not exist. Only then, shareholder-value-orientation should compel the management to carry through a buyback program.

Reference: Handicap Principle - Amotz Zahavi; 2020 Berkshire Hathaway annual meeting - Warren Buffett; Expectations Investing - Alfred Rappaport and Michael J. Mauboussin's.