Corporate Buybacks – Part II: Shorting the Buyback Contradiction

“To arrive at a contradiction is to confess an error in one's thinking; to maintain a contradiction is to abdicate one's mind and to evict oneself from the realm of reality”  –  Ayn Rand

The positive short-term price action of buybacks lures unsuspecting investors on the promise that such a shell game is sustainable. Many on Wall Street support such activities as it promotes rising stock prices, ultimately bolstering their wallets. However, clear-headed reason would argue that unless one is an executive whose compensation is tied to metrics influenced by the effects of share buybacks, there are few instances that support this use of corporate resources.

Those who promote buybacks base their support on the fact that fewer shares outstanding, a by-product of the share repurchases, produces more earnings per share (EPS) as the numerator in the EPS equation is unchanged while the denominator is smaller. In “Corporate Buybacks (Part 1); Connecting Dots to the F-word” we point out that most investors fail to consider the use of assets required to execute the buyback and the current valuation of those companies. Even more worrisome they fail to fully understand the implications of spending corporate capital to repurchase (often expensive) shares instead of investing it in the future growth of companies. The obscured shortcomings of share repurchases actually highlight a blatant contradiction. Share repurchases boost EPS, making valuations appear cheaper, however at the same time they reduce the ability of companies conducting such buybacks to grow future earnings. Recognition of this circumstance presents significant opportunities for those willing to embrace the “realm of reality”. This article uses logic and mathematical analysis to demonstrate the serious price distortions share buybacks are creating and offers specific trade recommendations to capitalize on those distortions.

Distortion

Buybacks distort financial ratios that many investors rely upon to evaluate stock prices. This is most evident in the widely used price to earnings ratio (P/E). This straightforward ratio simply divides the price per share of a company by its earnings per share. The resulting multiple tells an investor the price one must pay for each dollar of earnings. Investors calculating P/E can use a wide variety of historic, current or estimated future data for the denominator, earnings per share. On the other hand the numerator, price, is a known number – the current equity price of the company in question. Therefore, when using P/E as a valuation technique, the validity of the earnings per share input should be given careful consideration.