Cash Management

The Value of Share Buybacks

Companies shouldn't confuse the value created by returning cash to shareholders with the value created by actual operational improvements. After all, the market doesn't.

The McKinsey Quarterly
McKinsey & Co.

September 20, 2005

Share buybacks are all the rage. In 2004 companies announced plans to repurchase $230 billion in stock — more than double the volume of the previous year. During the first three months of this year, buyback announcements exceeded $50 billion, according to a McKinsey analysis. And with large global corporations holding $1.6 trillion in cash, all signs indicate that buybacks and other forms of payouts will accelerate.

In general, markets have applauded such moves, making buybacks an alluring substitute if improvements in operational performance are elusive. Yet while the increases in earnings per share that many buybacks deliver help managers hit EPS-based compensation targets, boosting EPS in this way doesn't signify an increase in underlying performance or value. Moreover, a company's fixation on buybacks might come at the cost of investments in its long-term health.

A closer inspection of the market's response to buybacks illustrates these risks, since some companies' share price declined — or didn't respond at all. For example, Dell's announcement earlier this year that it would increase its buyback program by an additional $10 billion didn't slow the decline of its share price, which had begun to slide because of worries about operating results.

Buybacks aren't without value. It is crucial, however, for managers and directors to understand their real effects when deciding to return cash to shareholders or to pursue other investment options. A buyback's impact on share price comes from changes in a company's capital structure and, more critically, from the signals a buyback sends. Investors are generally relieved to learn that companies don't intend to do something wasteful — such as make an unwise acquisition or a poor capital expenditure — with the excess cash.

EPS May Be Up, but Intrinsic Value Remains Flat
Many market participants and executives believe that since a repurchase reduces the number of outstanding shares, thus increasing EPS, it also raises a company's share price. As one respected Wall Street analyst commented in a recent report, "Share buybacks...improve EPS, return on equity, return on capital employed, economic profit, and fundamental intrinsic value." At first glance, this argument seems to make sense: the same earnings divided by fewer shares results in a higher EPS and so a higher share price. But this belief is wrong.

Consider a hypothetical example that illustrates how transferring cash to shareholders creates no fundamental value (setting aside for now a buyback's impact on corporate taxes), because any increase in EPS is offset by a reduction in the P/E ratio. The company's operations earn €94 million annually and are worth €1.3 billion (based on a discounted-cash-flow valuation with 5 percent growth). It has €200 million in cash, on which it earns interest of €6 million (Exhibit 1). What happens if the company decides to use all its excess cash to repurchase its stock — in this case, a total of 13.3 million shares (at €15 a share; the calculation assumes the shares are bought back at the current value)?

Since the company's operations don't change, its return on operating capital is the same after the buyback. But the equity is now worth only €1.3 billion — exactly the value of the operations, since there is no cash left. The company's earnings fall as a result of losing the interest income, but its EPS rises because the number of shares has fallen more than earnings have. The share price remains the same, however, as the total company value has fallen in line with the number of shares. Therefore, the P/E ratio, whose inputs are intrinsic value and EPS, drops to 13.8, from 15. The impact is similar if the company increases debt to buy back more shares.

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