The following research was jointly produced by: J. Brett Freeze, CFA of Global Technical Analysis and 720 Global
As we have previously noted, a large majority of companies, including 94 of the S&P 100, have actively repurchased shares since 2011. These companies often announce and execute share repurchases without providing a rationale to shareholders. As a fiduciary of shareholder's capital, managements' core responsibility is to act in the best interest of its shareholders.Unfortunately, we believe the majority of current repurchase activity is dictated by management's self-serving desire – temporarily inflating the current market-value of company stock, while enriching themselves through the exercise and sale of equity-based incentive compensation.
There are two conditions that should be met when a company engages in a stock buyback. 1) The shares should be trading below intrinsic value 2) there are no investment opportunities available that would allow the company to continue to grow at a desirable rate. If both conditions can be met a case may be made for share buybacks.
This article solely focuses on the first aforementioned condition– intrinsic value. For more information on the second condition, please read “In Yahoo, Another Example of the Buyback Mirage” by Gretchen Morgenson of the New York Times. In her recent article, which quoted 720 Global, she demonstrates how Yahoo weakened future earnings growth rates and corporate value through questionable stock buybacks.
Intrinsic value is not the market price or market capitalization of a company or its stock, but a theoretical value formulated through analysis of the balance sheet and income statement of the company.Conceptually, investors should seek companies whose share prices trade below intrinsic value and shun those trading above intrinsic value. This logic equally applies to corporate management executing buybacks.
When shares are purchased below intrinsic value, the company has added value. It is equivalent to buying a dollar bill for fifty cents.Conversely, share repurchases executed at a premium to intrinsic value destroy intrinsic value.Existing shareholders who sell are rewarded by the share-repurchase program, but those who hold are irreparably damaged. In the words of Warren Buffett from his assault on buybacks:
