Sent: 22-02-2011 14:10:53
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The Uncertain Impact of Share Buybacks
BHP Billiton is just another example of a company trying to come to terms with the ambivalence of equity markets toward corporate share repurchases.
There is no necessarily certain effect on a share price from a share buyback. Perceptions about why it is happening could outweigh otherwise potentially favorable valuation effects.
BHP Billiton announced on 16 February that it would spend US$10 billion over the remainder of 2011 buying back its own shares. A capital management initiative had been widely expected. The company's debt levels were relatively modest. It had failed to complete any of its planned big ticket acquisitions. Its cash flow for the first half of 2010/11 had been given a US$8.5 billion boost from higher commodity prices. Meanwhile, there was insufficient organic growth in the pipeline to fully account for its available financial resources.
Since announcing its buyback plans (and record profits and a 10% hike to the dividend), the share price has fallen by over 3%. One of the challenges for any company making a buyback announcement is to persuade investors they are going to be better off as a result.
One inference that could be drawn from a large share buyback is that the company has run out of investment options. This could be a reason to sell its shares and implies some risk of share price weakness.
Against this, a share repurchase implies a smaller number of shares on issue in future years and a higher level of earnings per share than would otherwise be the case. If the P/E ratio attributed to the company does not change, the share price should rise.
Of course, the P/E ratio is not independent of market conditions or the outlook for the business. The P/E itself will be influenced by the growth prospects of the company.
Confirmation that growth prospects have diminished could lead to a lower P/E rating. The combination of higher earnings and lower P/E could result in a permanently lower share price depending on their relative orders of magnitude.
Equity valuation models usually suggest that share prices are going to be a function of existing earnings, their future growth and investors' targeted rates of return. The problem for companies announcing a one-off share buyback is that there is no ongoing effect on future earnings growth and, therefore, no conceptual basis for a rising share price.
For there to be an effect on future earnings growth any share repurchases need to extend beyond the current year. In that case, the market can embed the resulting ongoing earnings growth in its valuation just as it would do for other sources of expected earnings growth such as increasing revenues from expanding markets.
Unfortunately, companies are often reluctant to commit further ahead than a few months because they want to retain their discretion to respond to unforeseen capital spending opportunities. At one level, such a precaution makes sense. Sometimes, however, it simply represents wishful thinking. Then, companies find themselves being forced into making a buyback as investors vent their frustrations over poor investment returns.
In recognizing management reticence to establish an ongoing share buyback program, investors will be reluctant to factor into their own valuations any ongoing impact on growth beyond the next confirmed instance of a buyback.
As a result, the potential market impact from periodic unforeseen repurchases could be less than if repurchases of a similar magnitude were undertaken as part of a regularly repeated cycle of stock repurchases that investors had come to expect and, consequently, embedded in their valuations.
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