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Why I always vote against trading company share repurchases

It has become increasingly common for listed UK companies to repurchase their shares on the stock market. I believe they often overpay, so that such repurchases harm continuing shareholders, and have done some calculations to illustrate how this happens.

Summary

24 March 2016

There is a great deal of misunderstanding regarding the effects of listed companies repurchasing their shares.

In my view some of this misunderstanding arises from the complexity of the subject and from theoretical arguments about capital markets. However, the cynic in me also believes that some of it arises from deliberate obfuscation by companies' managements.

Types of company

It is important not to confuse two completely different types of companies that are listed on the stock exchange which may engage in own share buybacks.

Investment trusts

These are one type of closed ended investment fund. The investment trust company has a fixed number of shares which are listed on the stock exchange. The company’s assets consist of investments, normally quoted investments but sometimes also unquoted investments.

There is no reason why the total market value of the investment trust (shares in issue x price per share) should equal the net asset value (the total market value of the investments held by the company after deducting any liabilities.)

When an investment trust is very popular, investor demand to purchase its shares on the stock exchange may well mean that the market price per share exceeds the net asset value per share. In this situation the shares are said to stand at a "premium."

A more common situation is for somewhat limited investor demand for the shares of the investment trust causing the share price to fall below the net asset value per share. In this situation, the shares are said to stand at a "discount."

For example, the investment trust may own investments which in aggregate are worth £20 million. If it has 1 million shares in issue, the net asset value per share is £20. However, the quoted market price on the stock exchange may only be, say, £18 per share. In this situation, one would say that the shares stand at a 10% discount to net asset value.

(£20-£18) / £20 = 10%.

Investment trusts sometimes repurchase their shares with the intention of reducing their discount. The effect of a share repurchase by an investment trust is illustrated numerically lower down on this page.

Trading companies

Most listed companies carry on a trade, either directly or through wholly-owned subsidiaries. Before computing the numerical implications of trading companies repurchasing their shares, it is worth considering the reasons often put forward for repurchases.

Excess cash

One of the oddities of listed companies' share valuation is that investors often value cash held by the company at below face value. In other words, if a company holds, say £10 million of cash on its balance sheet, and then “gets rid” of that cash, its market value is likely to go down, but by a lower number than £10 million.

With a little reflection, it is obvious why investors may value cash held by the company at less than face value. (There is no logical reason why holding £1 of cash should cause the company to be worth more than an extra £1.) Some of the reasons why that £1 of cash held may add less than £1 to the company’s market value are:

Accordingly, the repurchase of listed shares is often justified as a mechanism for the company to return surplus cash to its shareholders.

Increase earnings per share

The use of company cash to repurchase shares may cause the earnings per share to increase.

For example, if a company’s shares are quoted at £20 each, and they trade at a price/earnings ratio of 10, that means that the earnings per share are £2 per share. Interest rates are currently well below 10% p.a. so the interest that the company will be earning on £20 will be less than £2. If that £20 is used to repurchase one share, the arithmetic consequence is that the earnings per share for the remaining shares in issue will now be slightly greater than £2 per share.

As a justification for the repurchase, in my opinion this rationale is wholly specious. Nothing has changed about the company’s business and the increase in earnings per share is simply an arithmetical consequence of the share repurchase.

Company managements are often keen on such share repurchases because their remuneration targets are often linked to achieving particular levels of increases in earnings per share. I believe that company remuneration committees should always adjust management’s earnings per share targets to exclude any benefit to management from the increase in earnings per share arising from a company share repurchase.

This rationale for a share repurchase becomes even worse if the share repurchase is funded by extra debt (which inevitably increases the riskiness of the company).

Types of share repurchase

There are two basic ways in which a company can buy back some of its shares.

A tender offer

The company writes to all of its shareholders offering them the right (but not the obligation) to tender a specified proportion of their shares to the company for repurchase.

In that situation a shareholder can either tender no shares, or tender the maximum number of shares allowed under the offer's terms, or tender some number of shares in between. The choice rests with the shareholder.

If the shareholder tenders no shares, or indeed tenders fewer shares than the maximum, he is making a conscious decision to increase his fractional holding in the company’s trading business compared with the situation before the tender offer, while reducing his fractional interest in the cash that was held by the company.

A repurchase on the stock market

The company can simply go into the stock market and purchase some shares on the market. These shares are normally then cancelled.

UK law now allows companies to hold shares “in treasury.” The mathematical effect of shares being held in treasury is the same as cancelling them since companies do not pay dividends on shares held in treasury, since they would be paying those dividends to themselves. The only difference from simple cancellation is that shares held in treasury can normally be sold back into the market if the company wishes, which has the same effect as the company issuing new shares without giving existing shareholders the first opportunity to buy them (“pre-emption rights”).

When a company repurchases shares on the market, all continuing shareholders effectively have an involuntary increase in their proportionate shareholding in the company’s business and an involuntary reduction in their proportionate interest in the cash that has been used to make the share repurchase.

The alternative to a share repurchase

The main alternative to a share repurchase as a way of “getting rid” of excess cash is a "special dividend." This is simply a cash dividend paid equally on all shares of the company. It is normally referred to as a special dividend to ensure that shareholders do not expect it to be paid every year but instead recognise it as a special event.

A special dividend does not help an investment trust seeking to reduce its discount since it does not affect the number of shares in issue. However, as illustrated below it is an important alternative to be considered by trading companies which regard themselves as having excess cash.

Numerical illustration of repurchase by an investment trust

Prior to the own share purchase
Investments held by the company  £          20,000,000
Shares in issue               1,000,000
Net asset value per share  £                  20.00
Market price per share, say  £                  18.00
Cash spent in buying shares at market price, say  £            4,000,000
Shares repurchased at £18 per share                  222,222
After the own share purchase
Investments previously held by the company  £          20,000,000
Less sold to fund repurchase -£            4,000,000
Net assets of company  £          16,000,000
Shares in issue before repurchase               1,000,000
Shares repurchased -                222,222
Shares in issue after repurchase                  777,778
Net asset value per share                     £ 20.57
Share price after repurchase May increase

In the above example, since the investment trust was standing at a discount, the management have used some of its assets to repurchase shares at the market price. The mathematical consequence of repurchasing shares at a price below net asset value is that the net asset value per share of the remaining shares goes up.

In this example, the net asset value per share has increased from £20.00 to £20.57. That is a benefit to the continuing shareholders since they indirectly own more assets.

The above table simply says that after the buyback the share price "May increase." Unlike the net asset value per share, there is no mathematical linkage between the repurchase and the market price of the shares after the repurchase.

However in practice, the activity of the investment trust in repurchasing and cancelling shares often causes the market price of the shares to increase. Apart from anything else, the company represents an additional buyer beyond those buyers already active in the stock market. Indeed, the expectation that the company will buy back its shares may itself cause the discount to narrow.

Investment trust managements are sometimes reluctant to use share repurchases as a discount reduction mechanism because, as can be seen from the above example, it reduces the absolute size of the investment trust.

It is normal for external investment trust managers to be paid a fee which is set as a percentage of the total assets under management, so reducing the size of the investment trust reduces the fee that the external managers will earn. Also, if an investment trust becomes too small, its overhead costs will become a more significant burden on the shareholders since they do not normally reduce in proportion as the investment trust shrinks.

However, for large investment trusts overhead costs should not be a material factor in deciding whether to reduce the discount by repurchasing shares.

As a general principle, I support investment trusts repurchasing their shares at prices below net asset value.

Numerical illustration for a trading company

Illustrating the implications of a share repurchase for a trading company is significantly more complex than for an investment trust. Critical assumptions are required regarding how the market values the shares of trading companies. One needs to build a model which is sufficiently complex that it brings out the implications of the transaction while avoiding making the model so complex that one introduces errors or finds that one has made assumptions which force a particular outcome.

The linked Excel spreadsheet contains a model that I built while writing this article. The key assumptions are as follows:

The assumptions are set out in the table below.

Assumptions
12 PE ratio for business at Time T0
15 PE ratio for business at Time T1
9 PE ratio for business at Time T2
12 PE ratio for business at Time T3
100% Valuation ratio applied to cash at Time T0
100% Valuation ratio applied to cash at Time T1
100% Valuation ratio applied to cash at Time T2
100% Valuation ratio applied to cash at Time T3
 £    1,000,000 Annual earnings of the business at Time T0
 £    1,000,000 Annual earnings of the business at Time T1
 £    1,000,000 Annual earnings of the business at Time T2
 £    1,000,000 Annual earnings of the business at Time T3
Assume no retentions. All earnings paid out as dividends for simplicity
 £    8,000,000 Cash balance at time T0
       1,000,000 Shares in issue at time T0
             1,000 Shares held at time T0 by small shareholder who does not sell
 £    7,000,000 Special dividend at time T1 if paid
 £    7,000,000 Cash used for own share buyback at time T1 if undertaken
 £    7,000,000 Cash used for own share buyback at time T2 if undertaken

Taxation

Taxation is ignored. In practice many shareholders are not subject to tax on either dividends or the sale of shares. This applies for example to:

The model then considers the following scenarios:

  1. No corporate actions. I have assumed that the market price to earnings ratio starts at a particular level at time T0, increases at time T1, falls at time T2, and then rises back to the original level at time T3. However, the model is designed so that users can input their own choice of price to earnings ratio at each of these four points in time.
  2. A special dividend is paid at time T1 but there are no own share purchases.
  3. The company uses most of its excess cash to repurchase shares at time T1 when the market price to earnings ratio is “high.”
  4. Alternatively, the company uses most of its excess cash to repurchase shares at time T2 when the market price to earnings ratio is “low.”

In each scenario, I focus on calculating the value at each point in time of 1,000 shares held by a continuing shareholder who does not sell any shares. When the company pays a special dividend, obviously the cash received by that shareholder is also taken into account in assessing the value held by him.

1. No corporate actions

The table below computes the value of the shares held by the continuing owner of 1,000 shares. Obviously this value fluctuates as the market price to earnings ratio fluctuates.

Time T0 Earnings Multiple Market value
Corporate earnings  £           1,000,000 12  £   12,000,000
Cash on balance sheet  £           8,000,000 100%  £     8,000,000
Total market value of company  £   20,000,000
Shares in issue        1,000,000
Value per share  £           20.00
Shares held by small shareholder               1,000
Value of small holder's shares  £     20,000.00
Time T1 Earnings Multiple Market value
Corporate earnings  £           1,000,000 15  £   15,000,000
Cash on balance sheet  £           8,000,000 100%  £     8,000,000
Total market value of company  £   23,000,000
Shares in issue        1,000,000
Value per share  £           23.00
Shares held by small shareholder               1,000
Value of small holder's shares  £     23,000.00
Time T2 Earnings Multiple Market value
Corporate earnings  £           1,000,000 9  £     9,000,000
Cash on balance sheet  £           8,000,000 100%  £     8,000,000
Total market value of company  £   17,000,000
Shares in issue        1,000,000
Value per share  £           17.00
Shares held by small shareholder               1,000
Value of small holder's shares  £     17,000.00
Time T3 Earnings Multiple Market value
Corporate earnings  £           1,000,000 12  £   12,000,000
Cash on balance sheet  £           8,000,000 100%  £     8,000,000
Total market value of company  £   20,000,000
Shares in issue        1,000,000
Value per share  £           20.00
Shares held by small shareholder               1,000
Value of small holder's shares  £     20,000.00

The continuing owner has wealth of £20,000 at both time T0 and at the end at time T3.

2. Special dividend paid

The table below shows that the payment of the special dividend makes no difference to the value owned by this continuing shareholder. At all times the continuing owner has exactly the same wealth as he had in the above "no corporate actions" scenario.

Time T0 Earnings Multiple Market value
Corporate earnings  £  1,000,000 12  £    12,000,000
Cash on balance sheet  £  8,000,000 100%  £      8,000,000
Total market value of company  £    20,000,000
Shares in issue          1,000,000
Value per share  £            20.00
Shares held by small shareholder                1,000
Value of small holder's shares  £      20,000.00
Time T1 Earnings Multiple Market value
Corporate earnings  £  1,000,000 15  £    15,000,000
Cash before special dividend  £  8,000,000
Special dividend -£  7,000,000
Cash after special dividend  £  1,000,000 100%  £      1,000,000
Total market value of company  £    16,000,000
Shares in issue          1,000,000
Value per share  £            16.00
Special dividend paid per share  £              7.00
Shares held by small shareholder                1,000
Value of small holder's shares  £      16,000.00
Cash now held by small holder  £        7,000.00
Total value owned by small holder  £      23,000.00
Time T2 Earnings Multiple Market value
Corporate earnings  £  1,000,000 9  £      9,000,000
Cash on balance sheet  £  1,000,000 100%  £      1,000,000
Total market value of company  £    10,000,000
Shares in issue          1,000,000
Value per share  £            10.00
Shares held by small shareholder                1,000
Value of small holder's shares  £      10,000.00
Cash now held by small holder  £        7,000.00
Total value owned by small holder  £      17,000.00
Time T3 Earnings Multiple Market value
Corporate earnings  £  1,000,000 12  £    12,000,000
Cash on balance sheet  £  1,000,000 100%  £      1,000,000
Total market value of company  £    13,000,000
Shares in issue          1,000,000
Value per share  £            13.00
Shares held by small shareholder                1,000
Value of small holder's shares  £      13,000.00
Cash now held by small holder  £        7,000.00
Total value owned by small holder  £      20,000.00

A critical assumption for this table is my use of 100% for the proportion of the cash held by the company that is reflected in the market value of its shares.

It is quite obvious that if a lower percentage (e.g. 90%) were used then compared with the “No corporate actions” scenario payment of the special dividend would increase the continuing shareholder’s wealth. This is so obvious (because 90% means that £1 in the company is only worth 90p to the shareholder whereas £1 paid out as a special dividend is worth £1 to the shareholder) that there is no point in reproducing the numbers in this article.

However, I have flexed the spreadsheet on my own computer to put the matter beyond doubt. The results were as expected in the above paragraph.

3. Share repurchase at time T1

In this scenario at the end, time T3, the continuing shareholder is poorer (wealth of only £18,690.00) than he would have been if the share buyback had not taken place (£20,000.00).

Time T0 Earnings Multiple Market value
Corporate earnings  £      1,000,000 12  £      12,000,000
Cash on balance sheet  £      8,000,000 100%  £        8,000,000
Total market value of company  £      20,000,000
Shares in issue            1,000,000
Value per share  £              20.00
Shares held by small shareholder                  1,000
Value of small holder's shares  £        20,000.00
Time T1 Earnings Multiple Market value
Corporate earnings  £      1,000,000 15  £      15,000,000
Cash before share buyback  £      8,000,000 100%  £        8,000,000
Total market value of company  £      23,000,000
Shares in issue            1,000,000
Value per share  £              23.00
Cash available for own share buyback  £        7,000,000
Whole number of shares repurchased at above value per share              304,347
Cash before buyback  £        8,000,000
Cash used in own share buyback -£        6,999,981
Cash balance after buyback  £        1,000,019
Shares in issue before buyback            1,000,000
Shares repurchased -            304,347
             695,653
Valuation at time T1 after buyback Earnings Multiple Market value
Corporate earnings  £      1,000,000 15  £      15,000,000
Cash balance after buyback  £      1,000,019 100%  £        1,000,019
Total market value of company  £      16,000,019
Shares in issue              695,653
Value per share  £              23.00
Shares held by small shareholder                  1,000
Value of small holder's shares  £        23,000.00
Time T2 Earnings Multiple Market value
Corporate earnings  £      1,000,000 9  £        9,000,000
Cash on balance sheet  £      1,000,019 100%  £        1,000,019
Total market value of company  £      10,000,019
Shares in issue              695,653
Value per share  £              14.38
Shares held by small shareholder                  1,000
Value of small holder's shares  £        14,380.00
Time T3 Earnings Multiple Market value
Corporate earnings  £      1,000,000 12  £      12,000,000
Cash on balance sheet  £      1,000,019 100%  £        1,000,019
Total market value of company  £      13,000,019
Shares in issue              695,653
Value per share  £              18.69
Shares held by small shareholder                  1,000
Value of small holder's shares  £        18,690.00

The reason is that the share buyback happens at a point in time when the valuation of the company (measured by its price to earnings ratio) is higher than it is at the endpoint. Mathematically, continuing to own 1,000 shares means that on the date that the company carries out the share repurchase transaction, the continuing shareholder is involuntarily increasing his stake in the company’s trading business.

The effect is the same as if he had been paid a special dividend at time T1 and immediately used that cash to purchase extra shares at the market price at time T1.

4. Share repurchase at time T2

This is the converse of the previous scenario.

At time T2 the company’s valuation (measured by its price to earnings ratio) is lower than it is at the endpoint of T3. As the share repurchase causes the continuing shareholder to involuntarily increase his stake in the company’s trading business at a time when the shares are “cheap”, he ends up richer at time T3 (wealth £22,100.00) compared with the figure of £20,000.00 in the base case.

Time T0 Earnings Multiple Market value
Corporate earnings  £  1,000,000 12  £       12,000,000
Cash on balance sheet  £  8,000,000 100%  £         8,000,000
Total market value of company  £       20,000,000
Shares in issue             1,000,000
Value per share  £               20.00
Shares held by small shareholder                   1,000
Value of small holder's shares  £         20,000.00
Time T1 Earnings Multiple Market value
Corporate earnings  £  1,000,000 15  £       15,000,000
Cash on balance sheet  £  8,000,000 100%  £         8,000,000
Total market value of company  £       23,000,000
Shares in issue             1,000,000
Value per share  £               23.00
Shares held by small shareholder                   1,000
Value of small holder's shares  £         23,000.00
Time T2 Earnings Multiple Market value
Corporate earnings  £  1,000,000 9  £         9,000,000
Cash before share buyback  £  8,000,000 100%  £         8,000,000
Total market value of company  £       17,000,000
Shares in issue             1,000,000
Value per share  £               17.00
Cash available for own share buyback  £         7,000,000
Whole number of shares repurchased at above value per share               411,764
Cash before buyback  £         8,000,000
Cash used in own share buyback -£         6,999,988
Cash balance after buyback  £         1,000,012
Shares in issue before buyback             1,000,000
Shares repurchased -             411,764
              588,236
Valuation at time T2 after buyback Earnings Multiple Market value
Corporate earnings  £  1,000,000 9  £         9,000,000
Cash balance after buyback  £  1,000,012 100%  £         1,000,012
Total market value of company  £       10,000,012
Shares in issue               588,236
Value per share  £               17.00
Shares held by small shareholder                   1,000
Value of small holder's shares  £         17,000.00
Time T3 Earnings Multiple Market value
Corporate earnings  £  1,000,000 12  £       12,000,000
Cash on balance sheet  £  1,000,012 100%  £         1,000,012
Total market value of company  £       13,000,012
Shares in issue               588,236
Value per share  £               22.10
Shares held by small shareholder                   1,000
Value of small holder's shares  £         22,100.00

Conclusions from the above numerical illustration

The calculations show that the financial position of the continuing shareholder is critically dependent upon whether management causes the company to repurchase its shares when the valuation is “high” or “low.”

In practice when one looks at the justifications put forward by companies’ managements for share repurchases, valuation issues are never discussed. Instead management always appears to proceed on the assumption that the valuation question is irrelevant.

In my opinion the reason is that company management are conscious that if they sought to argue that shares should be repurchased because the market valuation was “low” shareholders and media commentators would be very sceptical about management’s ability to assess whether the valuation was indeed “low” or not.

While I have not attempted to gather marketplace data, my perception is that companies typically engage in stock market share repurchase transactions when valuations are “high.” Periods of high valuation are typically associated with high profitability within the companies concerned, generating significant amounts of cash, and with high levels of overall confidence amongst investors.

Accordingly, I believe that in most cases companies engaged in stock market share repurchase transactions are likely to damage the interests of their continuing shareholders because the repurchases are much more likely to happen when valuations are “high” than when they are “normal” let alone “low.”

Indeed, times when stock-market valuations are “low” are likely to be associated with reduced profitability within companies, lower amounts of cash potentially available for share repurchases, and greater pessimism amongst investors and company management deterring management from engaging in stock market share repurchase transactions.

Instead, I believe that if there is genuinely excess cash inside a company, it should be used to pay a special dividend to all shareholders.

My overall conclusion is that in the average trading company case a stock-market share repurchase is likely to damage the financial interests of continuing shareholders. I have therefore adopted the practice of always voting against giving trading companies' managements the authority to repurchase shares. As a single individual shareholder, my voting will not make a difference but it still makes a "statement".

More importantly, if other shareholders start to focus on this issue, the practice of trading companies will change because ultimately listed companies belong to us, the shareholders, and we collectively have the voting power to compel management to act in accordance with our wishes. That is why I have published this article and encourage readers to share it.

 

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