We also tested the return on investment (ROI) of buyback programs by using both a straight gain-or-loss methodology and an internal rate of return (IRR) approach.
Overall, these companies repurchased $1.80 trillion worth of their shares from 2004 through 2008, and the shares would have a market value of $1.96 trillion as of April 2011, resulting in a gain of $160 billion. The top gains were registered by IBM, Exxon, and Oracle, with the top 10 accounting for 90% of the gains.
The bottom 10 buyback companies repurchased $230 billion worth of shares at prices that averaged 94% higher than their prices are today. Not surprisingly, this group included many financial institutions, with the top losses registered by Bank of America, Citigroup, and GE.
Do such results represent a desirable use of capital? We applied an IRR approach to examine the average annualized ROI on these “investments.” We examined the cash outflows each quarter from 2004 through 2008 and estimated the number of shares repurchased at the average share price of the quarter. We then calculated an ROI relative to what those shares would be worth at the April 2011 share price. The top ROI was Netflix, with $300 million in repurchases now worth nearly $2.7 billion, for an ROI of 94%.
The median buyback company delivered an ROI of 3%, and three out of every four companies delivered a buyback ROI of less than 10%, a common hurdle rate for capital investment. For companies with rising share prices, buybacks amplified the increase. But for those with declining share prices, buybacks exacerbated the decline. In many cases, the only happy shareholders were the ones who sold shares back to the company when the share price was higher.
Given common buyback strategies, such poor results are almost inevitable. Many companies employ a pecking-order capital-deployment strategy in which cash in excess of reinvestment needs is distributed via share repurchases. While this strategy seems sensible, it leads to buying back more shares when the market value has increased significantly in response to stronger cash flows. This capital-deployment strategy seems flawed.
What are better buyback strategies? There are two reasonable choices. The first is to stop distributing capital based on availability and shift to a steady buyback program that distributes a consistent sum of cash every quarter. In effect, it means buying back more shares when prices are low than when they are high. That may be hard to stomach in a financial crisis, and may attract activist investors who abhor rising cash balances during good times.
The second is to continue with the pecking-order strategy but shift the variable portion of the distributions to a changeable special dividend. That way leverage and cash balances can be maintained while avoiding the typical propensity to buy back more shares when they are expensive. Either way, the shareholder will be better off.
Gregory V. Milano is co-founder and CEO of Fortuna Advisors LLC, a strategic advisory firm, and a regular columnist for CFO.com.