Why Shouldn’t I Count EPS Growth from Buybacks When Valuing a Stock?

Why Shouldn’t I Count EPS Growth from Buybacks When Valuing a Stock?

Someone sent me this email:

…you mentioned Omnicom, and you said that per share numbers should be avoided when computing growth…as you mentioned Omnicom buys back its stock, therefore why remove this information I have about this company from the implicit hurdle rate? Suppose we have 3 companies: a historically savvy buy backer, an automatic buy backer and a company who doesn’t buyback, shouldn’t we be able to discriminate between them if they were to all have the same FCF yield?

Answer: It’s Best to Assume Future Growth in Earnings Per Share Caused by Buybacks Will Be Tied to the Price at Which Future Buybacks Are Done

The reason I said you shouldn’t use per share numbers is to avoid double counting. Here’s what I mean.

You buy Omnicom at a P/E of 8.6 and a dividend yield of 5%. You know free cash flow is normally equal to or greater than earnings per share. However, in a recession like the one we’re in now for Omnicom – it’s likely free cash flow will come in below reported earnings. This would happen if there was a decline in billings (similar to how an insurer’s “float” drops an insurer takes in less premiums this year than last year).

So, what does that P/E of 8.6 and dividend yield of 5% buy you?

What I’m worried about is investors saying: “Well, 1/8.6 = 11.6%. My earnings yield is 11.6% AND the company has grown sales PER SHARE by 5% a year over the last 10 years. So, My return is 11.6% + 5% = 16.6% for as long as I own the stock.”

Now, I don’t doubt your return if you bought Omnicom today and sold it in the future could be 17% a year or higher. However, you’ll get that return from multiple expansion. Without the P/E multiple expanding, you won’t make 17% a year in this stock.

Why not?

There are two ways of looking at this.

One, you CAN count the earnings per share growth (or sales per share growth if we’re avoiding looking at changes in EBIT margins) and count the dividend. However, if you count the EPS growth – you CAN’T count the money used on stock buybacks. So, it’s a question of EITHER credit the company’s use of stock buybacks as if it’s as good as a dividend OR count the growth in per share figures caused by stock buybacks, but don’t count the growth in EPS caused by the falling share count.

Personally, I prefer counting all of the free cash flow used on buybacks and dividends as your “hold” return in the stock. I have a good reason for doing this that has to do with timing an investment in OMC to maximize your returns.

However, it is theoretically permissible to do the calculations as:

Dividend Yield = 5%

Sales Per Share Growth = 5%

“Hold” Return = 10%

I think this undervalues the stock as of today. But, that is more consistent with the “Dividend Discount Model” and other such ways of valuing stocks. This is a popular theoretical technique. I think it’s not all that practical though. For example, say the discount rate we want to apply is 10%. Well, OMC’s dividend yield is now 5%. Its growth in sales per share over the last 10 years has been 5% a year, its growth in earnings per share has been 9% a year, its growth in dividends per share has been 13% a year. Which is right? And – if we use 9% a year (which is very close to your discount rate of 10% a year) or 13% a year (which is greater than your discount rate) we’ll get a nonsensical reading on the intrinsic value of the stock. We know Omnicom is really only growing sales by about 2.5% a year over the last 10 years – the rest of sales per share growth comes from a declining share count. Also, this was a cyclical upswing in advertising from 2010 to 2020 (though really just the first 5 years of the decade), so actual revenue growth might be even lower. Obviously, you shouldn’t expect much organic sales growth from this company. So, what should you put in to the equation as your dividend growth rate: 13%, 9%, 5% – or something else?

I suggest something else. And it’s because I think there’s a better way to value the company that helps you decide when to buy and when to sell.

So, the dividend yield is the dividend yield. It’s worth whatever a dividend is to you. So, there may be a tax issue. Let’s pretend you don’t pay dividend taxes. If you don’t pay dividend taxes – then, a $100 investment in OMC by you would result in a dividend worth $5 being paid out to you. Since long-term investment grade corporate bonds only yield like 3.5% a year – this already sounds like a pretty good deal. Instead of getting a guaranteed payment from an investment grade corporation of $3.50 a year that can never grow in exchange for your $100 – you’re getting a non-guaranteed payment from an investment grade corporation of $5.00 a year that can grow in exchange for your $100. You’re also getting an equity kicker. That is 1/8.6 = 11.6% – 5.0% = 6.6%. So, you are getting this other thing when you buy OMC that is stated as being worth $6.60 a year. This is the non-dividend portion of what OMC is earning right now scaled to every $100 you put into the stock. That’s a big, big, big kicker. Also, that $6.60 figure understates the true value of this portion of your return.

Why does it understate the true value?

The “retained” portion of Omnicom’s earnings isn’t really going to be retained. I can’t promise they’ll use it to buy back stock – but, historically they always have. Earnings Per Share = Dividends Per Share + Stock Buybacks Per Share at Omnicom. That’s just been the rule historically. A dividend is worth what it says it’s worth less the tax you have to pay.

But, what is an allocation to stock buybacks worth?

The value of a stock buyback is dependent on the earnings yield of the stock it is used to purchase. This is a difficult concept for people to understand. I think they understand it superficially. But, they don’t realize the huge influence this has on a company making major allocations to stock buybacks as compared to other investment alternatives you have. For example, compare OMC stock to a bond. You have reinvestment risk in a bond. If the price of bonds rise, your return in reinvesting a maturing bond into a replacement for it will be lower. This happens all the time. You buy a 10-year bond yielding 5% and then in 10 years, you have to take the matured amount from that bond into a new 4% 10-year bond and so on. This will continue to happen as interest rates fall. The reverse could happen too. Rising rates (falling bond prices) mean you will be able to reinvest anything that matures at higher and higher rates. This kind of thing is a big deal for investors who just ladder bonds. For example, they have 1/7th of their money in bonds maturing in 2021, 2022, 2023, 2024, 2025, 2026, and 2027. When the 2021 bond matures, you buy a 2028 bond. You are always putting 1/7th of your money into bonds maturing in equal time periods of 1-7 years. In this case, I think people are very aware of reinvestment risk. They get that rising bond prices are bad for future returns, because as this year’s bond matures and you try to go out 7 years again you’re replacing a bond that was yielding more on your original purchase price with something that is now yielding less. Of course, investors also realize that bonds are marketable and that rising bond prices give you the chance to sell the bond before it matures and put the proceeds elsewhere. So, if you are laddering bonds you’re thinking that: 1) If bonds fall in price, I’ll get higher yields each time a roll this year’s maturing bond into a new 7-year bond and 2) If bonds rise in price, I can sell my bonds and put the proceeds in something else.

An investment in a company buying back its own stock works a lot like that. However, the stock is different from holding 1-7 year bonds in that there are certain things having to do with interest rates and multiple expansion and such that make the stock respond much more like a very long-term bond. Basically, if you buy a cheap stock that does well while it buys back its stock – you’re going to have a very big capital gain compared to what you’d expect owning bonds that mature in 7 years or less during a period of falling interest rates.

So, why do I say ignore that EPS growth rate?

Part of the EPS growth rate is based on the stock buybacks. But, in the future – how much will the stock’s earnings grow?

Here’s the secret: it depends on the stock’s price.

And this is what makes cheap stocks buying back shares such an amazing investment.

Imagine a bond you buy for $100 that has a 3% yield.

Now, imagine this is a very weird bond with some special rules written into how payments are to be made. If the bond continues to trade at $100 (par), you just get a 5% yield in cash. However, if the bond falls to certain price levels: $90, $80, $70, $60, etc. – the bond has to make additional payments to you. But, these additional payments aren’t in the form of higher cash coupons. These are “payments in kind”. You don’t get paid with more cash. You get paid with more bonds. And these additional bonds come with the exact same weird rules written into the bonds – you get a coupon and you get more bonds the further the stock’s market price falls.

That would be a pretty interesting bond to analyze, right? It could potentially be worth a lot more than bonds that have similar cash payouts but don’t have those weird rules written into the bond.

Now, there are no rules about what stock Omnicom or anyone else has to buy back. But, let’s pretend you knew they would buy back stock using the same percentage of their free cash flow regardless of the stock’s price. Well, that works a lot like the bond I described above.

So, you buy Omnicom at 17 times earnings. Omnicom’s FCF slightly exceeds its EPS. Omnicom pays all of its EPS (actually, a bit more than 100% of EPS) out as dividend and buybacks. If the stock has a dividend payout ratio of 50% and you buy it at a P/E of 17, your Omnicom investment works out like a bond with:

Yield: 3%

Perpetual Yield Growth: 3%

So, a $100 investment (at a P/E of 17) in the “Omnicom equity bond” would be expected to pay you:

Year 1: $3.00

Year 2: $3.09

Year 3: $3.18

Year 4: $3.28

Year 5: $3.38

And so on.

But, what if Omnicom’s P/E fell from 17 to 8.5. The dividend yield would rise to 6% instead of 3%. That’s easy. The “Year 1” number would go from $3.00 to $6.00. That’s obvious. What’s less obvious is what would happen to this coupon year after year.

Year 1: $6.00

Year 2: $6.36

Year 3: $6.74

Year 4: $7.15

Year 5: $7.57

This happens because the dividend will grow by 6% a year (not 3% a year) if Omnicom spends half its earnings buying back stock at a P/E of 8.5 and the other half paying a dividend.

What’s also interesting is what happens if the stock “returns to par”. So, say it trades at 8.5 times P/E for 5 years and then rises to 17 times P/E (which we’re going to pretend is the normal price for a stock like this). Well, if the stock is trading at 17 times earnings in a normal time – then, it should be trading at 34 times dividends (since dividend payout ratio equals 50% and 17/0.5 = 34). Therefore, $7.57 (the year 5 dividend) times 34 equals $257.38. You only put $100 into the stock 5 years earlier. That’s a 20% a year capital gain from buying something at half of par. That’s more than 5% a year higher than what you’d normally get buying something at 50 cents on the dollar that turns into 100 cents on the dollar in 5 years. Normally, a move from 50 to 100 over 5 years should only provide a 15% a year CAGR from capital gains. The additional capital gains came from stock buybacks being done at 50 cents on the dollar (P/E of 8.5) instead of being done at 100 cents on the dollar (P/E of 17).

This is a very important concept, because investors look at EPS growth instead of looking at returns on share buybacks. Imagine Omnicom stock goes crazy in the other direction (it gets too expensive) and management is allocating 50% of earnings to buying back their own stock at a P/E of 34. Well, that’s like having a bad weird bond instead of a good weird bond. It’s like having a bond where if it trades at $125, $150, $175, etc. you have to give some of your bonds back to the issuer to compensate them for selling you bonds too cheaply. This is because the coupon growth rate slows. At 34 times earnings, 50% of earnings are being used to buy back stock at about a 3% earnings yield. And only half of EPS is being put to that use. So, the coupon growth is only 1.5%. In other words:

Overvalued (P/E of 34) – Coupon Growth = 1.5%

Fairly Valued (P/E of 17) – Coupon Growth = 3.0%

Undervalued (P/E of 8.5) – Coupon Growth = 6.0%

I think all investors understate the “yield” part of overvalued and undervalued stocks. They get that paying twice as much for a stock reduces their dividend yield by half. But, they don’t get that if that company is also buying back stock – their coupon growth is also reduced. So, yes, people may buy Omnicom today because they like the 5% dividend yield. But, really, you should buy it just at much for the 6% of the company it could buy back this year if the stock price stays this low and they keep spending as much on buybacks as they normally do.

Finally, it’s worth noting that I simplified some math here. In reality, a 6% stock buyback per year causes EPS growth to compound at 6.4% more a year (not 6% more a year). This confuses some people – and at low percentages, the impact is rather small. So, I usually pretend buyback of x% of shares outstanding causes x% of EPS growth when in reality it always causes more.

The last practical point to make about cheap stocks doing big buybacks is a simple one. As long as the stock is one that’s cheap enough for you to hold (your expected return on the stock exceeds your self-imposed hurdle rate / “discount rate”) then buybacks are always the preferred method of returning capital. If you want a stock to pay you dividends instead of buybacks – you should probably sell the stock. Think of it this way: a good dividend yield might be 5%. So, simply selling the stock will give you 20 times more cash than the “cash income” you get from a dividend paying stock. If you need cash, don’t collect dividends – sell the stock. If you’d prefer having more stock over cash – well, that’s exactly what a stock buyback is. It’s the company using what could be your dividend to give you a greater ownership stake in the company instead of cash. And it’s putting off the immediate tax you’d pay.

This leads to a very simple rule. If you don’t want a company buying back stock – you don’t want the stock. Sell it. I mean, if the company buying back its own stock at too high a price hurts your returns – your returns would be best helped by you just selling the stock. So, the complaint that companies sometimes pay too much for their stock is a weird one. No shareholder should be holding stock in a company that’s buying back stock at a price the shareholder believes is too high – because, if the shareholder believes the price is too high, he should’ve sold the stock by now. Therefore, you should either be out of the stock or in favor of the buyback. Situations in which you keep owning the stock but disapprove of the buyback are irrational.

This means, of course, that you can benefit from a company that constantly buys back its stock by trading the stock. You only buy into such a company when its stock is really cheap. You hold the stock while it’s cheap (which, due to buybacks at low prices, means you enjoy unusually high EPS growth while holding) and then you sell the stock at the point where stock buybacks stop making sense. Yes, it’s true the company may be indiscriminately buying back stock. But, that doesn’t matter to you as a value investor. The buybacks are always good uses of capital while you own the stock. Once the price rises high enough to make the buybacks bad uses of capital – you sell to someone else. If this happens quickly, your CAGR contribution from capital gains is very large.

So, I think that’s a much better way of thinking about growth at a company buying back stock. Only count on organic growth to be stable. Assume growth in EPS driven by stock buybacks will depend on the P/E ratio at which stock is bought back. Buy stocks like Omnicom at low P/E ratios and benefit from the buybacks done at low prices. Then sell stocks like Omnicom at high P/E ratios where the buybacks would be less useful. Repeat as often as the P/E ratio of the stock goes through these cycles.

Get instant access to Geoff’s write-ups of stocks like Bonal (BONL), MSC Industrial Direct (MSM) , and Resideo Technologies (REZI) along with more than 100 stock write-ups already in the Focused Compounding archive. Plus, get 3 new stock write-ups a week from Geoff when you become a member of Focused Compounding (save 33% when you join for a year)