Buybacks are a great tool to reward shareholders — but the timing has to be right

Published Sun, May 21 202310:00 AM EDTUpdated Mon, May 22 20238:33 AM EDT

Share repurchases have become a hot-button issue of late in the U.S. Many politicians have railed against them, arguing companies should spend any excess funds on employees, rather than returning the cash to investors. At the Club, however, we prioritize investing in companies that buy back a lot of their own stock. In fact, an investment in a stock is predicated on the idea it will help a company to grow, generate cash and return a portion of that cash back to the investor. Simply put, a stock buyback is when a management team, authorized by the company's Board of Directors, repurchases shares in their own company — shares that were initially sold to investors when the company needed funds to grow the business. For example, company XYZ may show great promise in its early stages – perhaps, it has a disruptive new technology – but lack the funds to deliver on its vision. So, management offers investors equity in the company in exchange for cash. Ultimately, the company grows to the point of generating its own cash. Now, as all good businesses do, it comes time for XYZ to start returning cash to its shareholders. Management has two options to do so — either by paying out a dividend, or earmarking cash to repurchase some of the shares it originally sold as part of a buyback plan. Once repurchased, shares can be distributed to employees as stock-based compensation, held to be resold at a later date, or, as is more often the case, retired. Advantages When properly executed — generally, when shares are repurchased and retired — a buyback is a beautiful thing. Investors in a company who want to sell their shares have a willing buyer, while those that don't end up with a larger stake in the company due to the equity being divided among a smaller number of outstanding shares. Moreover, with fewer shares outstanding, earnings-per-share (EPS) increase, even if total net income remains the same. A buyback can ultimately drive shares higher over time, even without sales growth or margin expansion. Buybacks can be more advantageous than dividends, in part because the latter is a so-called taxable event. That means that the shareholder receiving that dividend will owe taxes on the income, generally in a range of 15% to 20%. But there is no taxable event for the shareholder when shares are repurchased by the company. Of course, for a buyback to make financial sense for a company, shares need to be purchased at an appropriate price. While a buyback in which repurchased shares are retired is always going to be accretive for future EPS, the question for a company's management team is whether the realized accretion was worth the cost — or if that cash might have been put to better use elsewhere. After all, should shares be purchased at too high a price then a management team could deploy cash only to see the value of what they purchased decline. Assume that XYZ Corp. generated $10 billion in sales with a 10% net profit margin and has 1 billion shares outstanding, resulting in EPS of $1. Now, if shares trade at 10-times earnings that would amount to a stock price of $10 per share — which multiplied by the 1 billion shares outstanding amounts to a $10 billion market capitalization. Then let's say the board of directors just authorized a $1 billion share-repurchase authorization. Excluding any subsequent share-price fluctuations, this amounts to a repurchase of 10% of the market cap. If executed at the $10 stock price, management would pull out of circulation and retire 100 million shares, leaving 900 million shares outstanding. Assuming there is no change in sales or the profit margin, EPS for those outstanding shares would increase by 11%, to about $1.11 apiece. And if those shares were to continue to trade at 10-times earnings, the stock price climbs to $11.10 per share for investors — tax free. Of course, should the company's sales grow and/or margins expand, the impact of the buyback would be even more impactful, giving shareholders a greater claim to the larger profit. Disadvantages Not all buybacks are rewarding. Like a good investment, a good buyback has to be made at the right time and, more importantly, at the correct valuation. All buybacks will be accretive, but the magnitude of the gains is going to depend on how many shares are pulled out of circulation. That's determined by both the amount of the board's repurchase authorization and the share price. If XYZ Corp. were trading at 15-times earnings, rather than 10-times — all else from the prior example being the same — the repurchase would have a smaller impact on EPS and, therefore, the stock price. At 15-times earnings, the stock would be worth $15 a share and management would only be able to repurchase about 67 million shares based on the $1 billion buyback authorization. Accordingly, both EPS and the stock — assuming the 15-times multiple held steady — would increase by about 7% as a result of the buyback, well below the 11% increase in the previous scenario. That would then beg the question for management — and shareholders — of whether the company should have utilized that $1 billion for other investments. Regardless, if the stock were to decline following the buyback, the repurchase would likely be viewed negatively by investors. While cash is always going to be the cost of buying back shares, shareholders need to be sure that management is getting the best bang for its buck — and that means getting the highest possible earnings benefit for every dollar deployed. The in-between Senior executives at a company often receive a large portion of their salaries as equity in the firm. The structure aligns management with shareholders, as their compensation is tied to the success of the company and, therefore, the stock. But it can also lead to conflict. Executives, for example, could have a bias toward buybacks because the immediate earnings accretion stands to benefit their stake. But that doesn't mean a buyback would necessarily be the best use of cash from a longer-term perspective. A buyback might provide a near-term earnings pop, but it does nothing in terms of new product innovation or other crucial areas of investment needed to fend off potential disruptors. Moreover, not all buybacks are created equal. A significant factor that differentiates one buyback from another is the practice of stock-based compensation for employees more broadly, in lieu of a cash-based salary. Assessing that practice can help an investor determine if a buyback is actually providing a shareholder with a greater stake in the company, or simply offsetting the dilutive effect of stock-based compensation. For example, when Salesforce (CRM) reported its fiscal 2023 fourth-quarter results in March, management announced a doubling of its share-repurchase authorization, to $20 billion. At a market capitalization of just under $200 billion, one might be inclined to view that as a greater than 10% return of capital to shareholders. However, management went on to explain that the buyback was intended to offset the dilutive impact of share-based compensation for the entirety of fiscal 2024. That means shareholders won't ultimately own a bigger piece of the company, even though they will benefit from Salesforce offsetting the dilution caused by stock-based compensation. While that's a net positive for shareholders, it's not the same as, say, Apple' s (AAPL) approach to buybacks. In the iPhone maker's December quarter, it repurchased roughly $19 billion in stock, while paying out a little under $3 billion in share-based compensation — translating to an actual increase in shareholders' ownership stake in the company. The practice of using a buyback to offset share-based compensation brings up another topic of contention – the impact it has on cash flows. Whereas cash-based compensation is considered an operating-cash line item, stock-based compensation is a non-cash expense and share repurchases are classified aspart of financing cash. And that can mask a company's cash-flow profile. If a company were to payout salaries in cash, that would be reflected under operating cash. However, by paying employees in stock and subsequently repurchasing shares via a buyback, a company can buffer operating cash flows by moving the payout to the financing-cash line item. That would also have implications for the company's free-cash-flow calculation, which is generally defined as operating cash flow less capital expenditures. That alone may not be reason enough to avoid a stock, but certainly should be a factor investors consider when analyzing stock-based compensation and buybacks. Moreover, its vital to consider whether a company is maintaining a sound balance sheet, including a fund for a rainy day. As much as we appreciate a large buyback, we still must hold management accountable and be sure that a company's top executives are keeping the long-term health of the business top of mind — and that should always take priority over a buyback. (See here for a full list of the stocks in Jim Cramer's Charitable Trust.) As a subscriber to the CNBC Investing Club with Jim Cramer, you will receive a trade alert before Jim makes a trade. Jim waits 45 minutes after sending a trade alert before buying or selling a stock in his charitable trust's portfolio. 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The New York Stock Exchange in New York, March 28, 2023.

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