By: Grover Grafton
Cannibals you say?
Yes, more specifically Corporate Cannibals who can't help but eat their own stock and buy out their partners. So how should we think of this very in vogue method of capital return? When does it make sense, when doesn't it, and who are the buyback MVPs?
What's a Buyback & Its Business Purpose?
A buyback is when a company, as part of a tender or open market activity, repurchases the equity interest of its partners and reduces its shares outstanding. Effectively buying out partners in the business who, at the price offered by the market/company, wish to cash out as opposed to remaining an equity owner/partner in the business.
When does this make sense?
The short answer is whenever the shares (ownership interests) trade at a discount to their conservatively calculated intrinsic value or, weighing opportunity cost, serve as a better opportunity than presented by any other business activity.
A Story:
Imagine you and two friends own a McDonald's franchise. For simplicity, you each own a third interest with a conservative value of 1M (3M for the whole franchise). If one of your friends wants to move to Tahiti with his wife and cash out of the franchise, one method of doing this is to have the franchise itself buy him out. This leaves the two remaining partners with a 50% interest, up from 33.33%.
But... is this a good decision?
The answer is, it depends. If the friend who wishes to sell out wants 2M for his interest, this transaction is massively value-destructive. Yes, you will own more of the franchise, but the franchise will be worth less to a more significant degree than your interest was increased.
However, if this friend wants 0.8M for his interest, this transaction makes sense. The franchise lays out 0.8M and receives 1M in value (20% return), you and the remaining friend increase your interests, and the franchise ends up with a more long-term minded ownership pool. All are constructive and value-accretive.
Similarly, if this friend wants 1M for his interest and the franchise has no better opportunities to deploy 1M dollars at a return greater than 0%, it would also make sense to complete this transaction.
Benefits:
Buybacks are tax-advantaged compared to dividends, as shareholders don't have to pay taxes on the distributions or the effective increase in ownership stakes, unlike dividends, which are subject to capital gains or qualified dividend taxes.
The business is buying out willing sellers who self-select and leave long-term shareholders clinging to their interests. This results in a long-term shareholder mindset.
Buybacks are variable and subject to management's discretion, which allows for a degree of opportunistic cannibalism (when your friend offers to sell at a cheap price), compared to dividends, which put management in golden handcuffs that might restrict them from engaging in opportunistic buybacks and similar business investments.
The Catch?
Buybacks as a successful method of capital return are dependent on a shareholder-minded and savvy management team.
Current MVPs:
Over the past 10 years, these companies have repurchased the listed percent of their shares back. (Have Fun Hunting)
Dividends or Buybacks
Dividends Rock!
Buybacks Rule!
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