This page has been archived and commenting is disabled.
Shorting The Buyback Contradiction
Submitted by Michael Lebowitz via 720Global.com,
“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; 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.
The reality is that stock buybacks distort EPS data and produce lower P/E ratios, thus making the shares optically cheaper. As an example, consider a company with a $20 price per share, $1 EPS and plans to buyback half of their outstanding shares. Upon completion of the buyback, the company’s P/E will drop from 20 to 10 as the price remains at $20 but EPS will double to $2, due to the reduced share count. This P/E distortion (an investor now only needs $10 to claim $1 of earnings instead of $20 prior to the buyback) will likely lead investors to conclude that the equity is cheap. However, investors have failed to consider the use of cash to purchase the stock and the now impaired ability of the company to fund and produce future growth.
Analysis
For this analysis, we considered publicly traded companies listed on U.S. stock exchanges with a market capitalization greater than $5 billion. To quantify the distortions to P/E created by share repurchases, a buyback “adjusted” P/E is calculated. This adjusted P/E ratio normalizes EPS, the denominator, by assuming NO shares were repurchased since 2011. Normalizing EPS in this way reduces the denominator and therefore increases the P/E ratio. Comparing the current P/E to the adjusted P/E gives one some sense for just how much buybacks may be distorting values. To illustrate, the adjusted P/E of the company used in the example above would be 20, instead of the post buyback P/E of 10. The distortion of P/E highlights how buybacks may lead investors to misinterpret value and then misallocate investment capital.
Of the over 600 companies analyzed, including 99 which did not conduct buybacks, the average adjusted P/E was 3.99 higher than the average non?adjusted P/E. Based on the trailing 12 month S&P 500 P/E of 18.25 currently present in the market, investors are unknowingly invested in an adjusted market P/E which is over 20% higher than they assumed. Buyback distortions are larger than ever and not limited to any one industry grouping. The table below shows the average distortion to P/E by industry.
The following tables expand the analysis by detailing the P/E distortion for individual companies. Company specific analysis was limited to the S&P 100 to ensure we highlight widely held companies that can be easily traded from the short side and have liquid option offerings.
Within the S&P 100 six companies were selected based upon a combination of large P/E distortions and the magnitude of recent share buybacks versus total outstanding shares.
The Contradiction
When investors pay an above?market P/E for shares they are frequently betting that the company will deliver higher future earnings growth than the market. The table below uses the adjusted P/E of the six companies to calculate the annualized required EPS growth. The required EPS growth is the pace at which earnings must rise in order to align the adjusted P/E with the current market price to earnings ratio without requiring a discounting of current share prices. In other words, how much does EPS have to grow to reduce the company’s P/E to equate it with a market average P/E? Revenue growth is a sound proxy for earnings growth as a company cannot grow earnings more than sales in the long run. In the table below, annualized revenue growth is also included for the last 3 and 5 years.
Consider the large gap between the required EPS growth rates and historical revenue growth rates. The transparency of the adjusted P/E reveals that the required EPS growth hurdle has risen to seemingly unachievable levels. Given these large differences, investors should be alarmed that these companies have limited and continue to constrain their ability to grow by using cash for buybacks. Using these resources for the purposes of buybacks makes them unavailable for projects that might generate those earnings! Those that believe buybacks are a vote of confidence by management in the company should carefully reconsider that opinion and the inherent conflicts buybacks create.
Trade Recommendation and Conclusion
Aggressive investors can take advantage of this analysis by shorting the six highlighted companies on a market neutral basis and countering the short positions with long positions in companies offering fair valuations. Conservative investors may want to sell holdings in these firms or shy away from future purchases in them.
P/E ratios calculated with past, present and future EPS along with many other valuation techniques currently register in the extreme upper tiers of historical readings (click here to reference “Courage” in which we illustrate the currently rich valuations). Investors in companies or indices containing a significant number of companies conducting buybacks should carefully consider the effects, distortions and long term ramifications of share buybacks.
The contradiction of buybacks is apparent; a company should not have a higher P/E multiple resulting from buyback actions when those actions at the same time reduce the company’s ability to achieve the additional growth required to justify the higher P/E multiple.
The best way to avoid the permanent impairment of capital is to never overpay for an asset.
»
- 16133 reads
- Printer-friendly version
- Send to friend
- advertisements -
The American CURSE is alive and well. Our actions on earth have spiritual consequences. And those consequences are reflected in our financial dealings as well. Hence, the distortion referred to in the article is one such curse.
https://biblicisminstitute.wordpress.com/2014/07/17/is-america-cursed/
Speak for yourself mother fucker, mine is clean.
Aym Rand was a contradiction herself?
Contradictions are but an innate conflict. A subliminal freudian function pitting the inverse of tyme present in what paradoxically could by chance be an infinitesimal truth in the future.
Reality's-- be it fiction or non-fiction are the greater sum's of all intrinsic knowledge imagined or established therein as critical thought.
It is said that absence makes the heart grow fonder,... but, that familiarity breeds contempt.
Which is a contradiction?
Simply put man is a contradiction in a realm he does not understand or an existense he cannot explain! Always questioning axioms and dogma's long after his usefullness has imploded any semblance of rational arbitration. Always stubling over his fork-tongue as a snake makes its way into the contradicting closed-mind of a Godless entity before the simplicity of a symbiotic paradox capitulating to self`construct enigma balancing atop a apex-nadir self destructive ballistic pendulum...[?]
jmo
Magical thinking will get you supporting your killers.
There's going to be a lot of corporations that disappear down the great well of stupidity when the stock market takes a shit. As long as the stock price is shiny and the bent up numbers look good with nice bonuses for the right people, things like cap-ex and sales are mere bagatelles to be ignored and degraded......
and I know damn well when it blows up, me and my coworkers are going to get the shaft, while the executives exercise their multimillion dollar parachutes that were guaranteed regardless of any performance or world events
Buyback (Brokeback) Mountain ... of debt ...
"DO NOT READ this sign under penalty of law"
Sounds like
http://178.209.48.7/ad.doubleclick.net/" style="display: none;" rel="nofollow" Do NOT follow this link or you will be banned from the site!
Amish Bitchez!
http://amishoutlaws.com/amish_steppin805.jpg
Hey kids, czech this out. Hi Def SUNGLASSES!
http://www.walmart.com/ip/As-Seen-on-TV-HD-Vision-Ultra-Sunglasses/14248109
(I was under the impression the world was already in Hi-Def.)
I'm currently working on 3D sunglasses. Paint all your possessions in this wonderful product, and VIOLA! All your stuff looks like it's really there!
Do you really feel sorry for the masses who lose money. If people are dumb enough to buy this crap, they deserve to be poor.
http://www.reuters.com/article/2015/07/30/us-usa-eximbank-general-electric-idUSKCN0Q42J920150730
General Electric Co is taking steps to shift some U.S. manufacturing work overseas now that the U.S. Export-Import Bank will be shuttered at least until September, the industrial giant's global operations boss told Reuters on Thursday.
GE Vice Chairman John Rice said the conglomerate is bidding on over $10 billion worth of projects that require support from an export credit agency (ECA) like Ex-Im.
With Ex-Im unable to extend new loans or guarantees thanks to an effort by congressional Republicans to shut it down, GE is arranging with ECAs in other countries to finance the deals involved, with much of the production going to GE plants in those foreign locations. The prospective government partners include Canada, the United Kingdom, France, Germany, China and Hungary, he said.
"We're submitting the tenders now. So we are identifying where we'll bid this and the ECA support that comes with it, and it's not in the United States," Rice told Reuters in a telephone interview from Atlanta
Ex-Im has been unable to consider any new financing requests since Congress allowed the bank's charter to expire on June 30.
Rice's comments come as the U.S. Congress starts a five-week summer recess with no clear path to revive Ex-Im in the months ahead. A group of conservative Republicans, who say the 81-year-old trade bank is a nest of "crony capitalism" that doles out government welfare to GE, Boeing Co and other wealthy corporations, want to keep it closed for good.
An effort to revive the bank as part of a multi-year transportation bill won strong support in the U.S. Senate, but stalled this week when the House of Representatives approved a short-term funding extension without the Ex-Im provision.
Boeing chairman Jim McNerney on Wednesday said the aircraft maker was actively looking at moving "key pieces" of its operations to other countries that could offer export credits.
Rice, who is based in Hong Kong, said GE is not moving to shift work and jobs overseas "just to make a point" to Congress, but to win contracts that require export credit agency support. "We're doing this because if we don't, we can't submit a valid tender," he said.
In one such power-sector bid, for example, GE would do final assembly work on its aero-derivative gas turbine power generation units at GE plants in Hungary or China instead of a factory in Houston. It already has capacity in place, and export credit agencies willing to support the work, he said.
"Next year, if we win this bid, work that would have been in Houston will be someplace else," Rice said.
GE also is seeking financing from another country's export credit agency to save a $350 million locomotive deal with Angola that has lost access to Ex-Im support, Rice said. =========More here======= Is G.E. The Real Reason Paulson Panicked In The Aftermath Of Lehman? - Shrieking Cries Of Immelt Pain GE Dumps Offshore Wind-Power Plans AFTER Collecting $125 Million In Stimulus From Taxpayers For Wind Projects
Read my first link at the end of my post above re: Paulson and note what GE got 4 days after TARP was passed.
Then watch this short video and note what happened 4 days after the passage of TARP.
https://www.youtube.com/watch?v=RmPUKy-3OfY
"I am a tolerant, peace-loving Christian; I support the state of Israel."
Contradiction, no?
Buybacks are just the normal financial process of ballance sheet reengineering. When debt is cheap you get rid of equity holders as they're more expensive, when debts expensive you issue shares. This is a non story.
EX-10.16 dot blaa, blaa.. blaa
http://www.sec.gov/Archives/edgar/data/1408278/000119312512028545/d253349dex1016.htm
Just in that phrase you can see the totally dogmatic Mindset of Ayn Rand whose objectivism is an expression that tolerates no philosophical UNCERTAINTY.
Philosophyby essence, if it espouses the study of reality, has to accept uncertainty; as all projection into the future of man is FRAUGHt with uncertainty. No thinker can avoid facing a contradiction of his theory if empirical verification of his conceptual projection proves his thinking wrong. And no thinker can disregard the contradiction in his model until empirical proof of consequence has not allowed clarification of the premise.
Contradiction is the spice of empirical method. We learn from trial and error. And Rand could NEVER accept that her belief of material aggrandisement of man being his very essence of soul and life was in itself a subject of conjecture and therefore open to contradiction.
But dogmatists hate their premises be contradicted; like self aggrandisement is the "very essence of a life well spent". What if it isn't? What if sharing with others is a better tradeoff? WHen the premise is open to contradiction your whole life can be a sterile quest. Something you may find out on your dying day !
Jesus was no follower of Rand's objectiivism.
excellent...
Bravo!
Jesus was no follower of Macroeconomics either. Jesus followed his father in heaven, but even God knows that turning over the tables of the money changers in the temple was just tokenism and acting on the part of his only begotten son.
Lucky for God that I finished the job properly, eh.
:|
Ayn Rand was not perfect by any stretch, but your interpretation of her position is grossly unfair. She does not ignore uncertainty, or pretend uncertainty is invalid, or pretend uncertainty is a failure of intellect.
You're just flat out wrong about that conclusion.
In fact, it is precisely the "discovering contradictions, inconsistencies, strangeness or errors in your thinking" that informs a thinker they need to review every input to their thinking process on the topic, and attempt to find the mistaken input, or the faulty process that led to the inappropriate result.
I have a core premise that underlies ALL of my thinking. That is, every conclusion is a "provisional inference". In other words, uncertain. However, that's not enough. My estimated degree of uncertainty must be estimated and stored with every conclusion (provisional inference). And this estimate must be accessed and considered every time that conclusion becomes part of subsequent thought processes --- or actions!
I believe Ayn Rand would agree with the above. True, she never said what I said in the same words or terms (as far as I know), but my provisional inference from what I've read of hers is... she would agree.
The basis of the above is, of course, the fact that no sentient being has... or could possibly have... all the input (sensation and perception) required to arrive at certain conclusions on non-trivial issues.
Having said the above, I need to make one thing clear. I hold only three ideas as "absolutely certain" and not "provisional inferences". However, in the conventional meaning of the term "certain", I am certain about a great many things. Put another way, I am willing to say "I am certain about xxxxx" when I figure my probability of error is in the rough neighborhood of 99.9999% or greater.
Ayn Rand also did not believe that "material aggrandisement of man was the essence of soul". How anyone could read Atlas Shrugged and come to such a conclusion about her is totally beyond me. In fact, if that statement was true, her heroes would be "crony capitalists" (in other words "fascists") who controlled government. Because nothing would satisfy the criteria you mention better than that. Instead, they vanished so they could life simple lives on a small scale... or became pirates who endangered their entire lives (pirates that did not keep the loot, incidentally).
Ayn Rand definitely has her faults. The very notion that "government" is real, and needs to exist is indeed a contradiction of her more fundamental philosophy. But somehow you got a grossly distorted idea of what she actually thought.
BTW, I appreciate that you are interested in philosophy and take philosophy seriously. Sadly, too many people think philosophy is impractical. And indeed, almost all philosophies are worse than impractical, they're dangerous. But valid philosophy is massively practical, as you appear to understand.
adam smith, or any other freemarket capitalist believers, theorist didn't figure in the cloward piven, BIS, bought politicians, and the lbj theories, which is the world we live in today,if you offer humans a chance to get something for nothing, 50% will take that deal, whether it's $2,000.00 a month living in hell on earth for grenerations, or it's for $ 10's of millions in bonuses, and prophit selling back your price inflated shares,
I don't want to get biblical, but adam, and eve, had the whole world, except for that one apple, welcome to 2015.