Tuesday, October 5, 2010

Debt + share buybacks = shareholder value?

We all hate to see excessive debt when analyzing companies or stocks for potential investment. We hate it even more when a company we have invested in takes on more debt than it can very comfortably service.

But we shouldn’t necessarily panic every time a company we own stock in borrows money, as leverage, used in moderation, can help a company increase shareholder value. Companies that have a low cost of debt capital can borrow money to fund strategic acquisitions or reinvest in their operations at higher rates of return, refinance higher interest debt, and buyback shares (the main focus of this article), all potential value creating undertakings.

By taking on debt and using the money to buy back shares, companies can actually increase their earnings per share. Say for example a company has 10 shares outstanding valued at $100 or $10 a share and has EPS of $1. If the company borrows $20 at 2% to buy back 2 shares, there will only be 8 shares outstanding, and each share will now earn $1.2 after taking into account the interest cost and the fact that the profit is divided among fewer shares.

Each share should also have a higher valuation in time as reflection of higher EPS and higher ownership interest each share has in the company, assuming of course that the additional debt didn’t push the company’s debt load past levels that can be considered safe, which causes investors to assign a lower valuation to the company.

No matter how low a company’s debt level is, or even if the company doesn’t have any debt at all, a company should always be incredibly cautious when using leverage. The following are some things to look at when analyzing if a company’s leveraged share buyback undertaking is reasonably safe:

Manageable debt

The company should have low debt and a good interest coverage ratio. To see if debt is manageable, I generally look for current assets to be about 40% of total liabilities and 150% or at least equal to current liabilities; for the interest coverage ratio, I generally look for companies with an interest coverage ratio of at least 2 to 2.5. Cash can be lower if the company’s interest coverage ratio is high.

Undervalued shares

When a company wants to buy back its own shares, it has to make sure that its shares are undervalued in the first place or it can end up destroying shareholder value instead of creating shareholder value. As a shareholder you own part of all the assets in the business, and you wouldn’t want management spending your cash on overvalued investments (even if it happens to be the company’s own stock), would you? So, if you think the stock is cheap according to your own analysis, then you should view a plan for a share buyback program as a good thing and vice versa if you think the stock is overvalued.

Low interest

Companies should only borrow money if the cost of debt is cheap. The lower the interest rate on the debt taken on to buy back shares, the wider the spread between the earnings yield and the interest expense, which translates to the leveraged share buyback program being more likely to create value and create better value for shareholders. A low cost of capital also means that the company will have an easier time servicing its debt.

Good management

Investors can have more confidence that the planned leveraged share buyback program will be a success if the company is run by management that has a great track record of doing what they say, launching successful share buyback programs, and creating shareholder value in general. Investors should generally invest only in companies with good management, and not be worried about management quality only when things like large share buybacks are on the horizon.

If you have any questions, or have anything you would like to share, please feel free to comment. Thank you for reading, and may you always sustain good returns on your portfolio.