Yesterday, I mentioned Warren Buffett’s annual letter to investors. Today, let’s take a closer look at one of the topics he raised — share buybacks. Chances are that you own a company (or will in the future) that announces a share buyback.
Just yesterday, QBE Insurance [ASX:QBE] announced a $1 billion share buyback. And Coca Cola Amatil [ASX:CCL] recently announced a $350 million repurchase of its shares along with its half year results.
I’ll have a look at these deals in a moment and see if they benefit shareholders. Because, as Buffett points out in his letter, not all share buybacks create wealth for shareholders. If you know what to look for, as a shareholder you’ll have a good idea of whether you should participate in these types of deals or not.
As Buffett says:
‘…repurchases only make sense if the shares are bought at a price below intrinsic value. When that rule is followed, the remaining shares experience an immediate gain in intrinsic value.
‘Consider a simple analogy: If there are three equal partners in a business worth $3,000 and one is bought out by the partnership for $900, each of the remaining partners realizes an immediate gain of $50. If the exiting partner is paid $1,100, however, the continuing partners each suffer a loss of $50.
‘The same math applies with corporations and their shareholders. Ergo, the question of whether a repurchase action is value-enhancing or value-destroying for continuing shareholders is entirely purchase-price dependent.’
He then goes on to explain Berkshire’s share repurchase policy:
‘I am authorized to buy large amounts of Berkshire shares at 120% or less of book value because our Board has concluded that purchases at that level clearly bring an instant and material benefit to continuing shareholders. By our estimate, a 120%-of-book price is a significant discount to Berkshire’s intrinsic value, a spread that is appropriate because calculations of intrinsic value can’t be precise.’
OK. In these two quotes, Buffett gives you everything you need to know about share buybacks and whether they add value or not. But as always, he doesn’t spell it out precisely. You have to think about it a bit.
The first question you probably have is: What is intrinsic value? How do you know whether a company is buying above or below its intrinsic value?
This is where it gets tricky. Like beauty, value is in the eye of the beholder. What is cheap for one investor might be expensive for another. That’s because any intrinsic value calculation depends on the inputs and assumptions made.
Calculating intrinsic value
I’ll give you a very simple example of how Buffett estimates intrinsic value. His two main inputs are ‘return on equity’ and the ‘discount rate’, also known as the ‘required rate of return’.
As far as I’m aware, Buffett has never disclosed what his ‘required rate of return’ is. But based on what he has said, he adds a premium to the 10-year US bond yield.
To keep things simple, let’s say his required rate of return is 5%. And assume that the company he is valuing generates a consistent 10% return on equity.
The intrinsic value, then, is the amount Buffett would need to pay in order to achieve his required rate of return. Assuming this company pays out all of its earnings as dividends (that is, it doesn’t reinvest anything) Buffet would not pay any more than two times book value to achieve his required return.
I get that number by dividing the 10% return on equity by the 5% required return. Book value is the same thing as equity value. So if you’re paying two times equity value for a stock, and the equity generates a return of 10%, then as a part owner of that business you will earn a 5% return.
As this matches your required rate of return, intrinsic value is two times book value, or, in Buffett’s parlance, 200% of book value.
As Buffett states above, he is authorised to buy back stock at 120% or less of book value. That is, 1.2 times book value. He says that at this level, Berkshire stock is materially below intrinsic value.
But the valuation of Berkshire isn’t as simple as the example I gave above. That’s because it reinvests ALL its earnings. By doing so, it’s compounding wealth faster and justifies a higher intrinsic valuation. This is really the secret of Berkshire’s phenomenal performance over the decades.
As long as it generates a return over and above its required rate of return on its reinvested earnings, Berkshire’s share price will continue to climb.
There is no other company in the world that has been able to reinvest all its capital and earn a strong rate of return on that capital over a sustained period. This magic of compounding (and Buffett and Munger’s investing genius) is what makes the company so unique.
CCL versus QBE
Let’s turn to CCL and QBE now to see whether their recent buyback decisions make sense…
CCL generates a return on equity of around 20% and has done for years. It trades at 3.7 times book value and pays most of its earnings out as dividends.
For the buyback to make sense at current prices, then, the required rate of return must be around 5.5% (20% divided by 3.7).
That might be OK (just) for a super fund paying a low tax rate, but it’s probably not OK for you. A required return of 5.5% from a company struggling to grow profits (earnings per share are around the same as they were in 2007) isn’t great.
In my view, CCL’s share buyback won’t enhance value for existing shareholders.
What about QBE?
It announced a $1 billion buyback over three years, but failed to mention at what price. It generates a return on equity of around 8% and trades at 1.1 times book value.
But the thing to keep in mind is that QBE is slowly improving its performance after years of disappointment. It’s targeting an increase in return on equity to a long-term range of 13-15%.
If this is the true long-term earnings power of the business, then it makes sense to use the higher number, rather than the current, cyclically depressed number.
On this basis, we divide 14% by 1.1 to get a required return on 12.7%.
That’s more like it. If QBE continues to improve profitability in the years ahead, its three-year buyback program (assuming the share price doesn’t rise TOO much) will create additional value for existing shareholders.
The conclusion? On capital management initiatives, sell CCL and buy QBE!