How to tell if a company 'share buyback' makes sense

Share buybacks when companies buy their own shares on the stock exchange and cancel them are all the rage again. In America, they are back at the same levels that we saw before the financial crisis, according to data firm FactSet. They are very popular here in Britain too.

So let's make one thing clear right away. We don't like buybacks. If a company wants to return cash to shareholders', we'd rather have a dividend payout. This is money in the bank that can't be taken away again in the future.

The truth is that buybacks are mostly done for the benefit of management teams (their bonuses are often based on earnings per share (EPS) the fewer shares in issue, the higher the EPS, even though underlying profits stay the same).

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That said, some buybacks make more sense than others. Whether you're an individual or a company, investing is all about getting a decent return on your money. If a company buys its own shares at the right price, a buyback while nowhere near as attractive as a dividend can be a good use of company money. But how can you tell the difference?

Next's sensible buyback model

If a company borrows money, it can claim tax back on the interest payments. So, as long as the earnings yield (the inverse of the price/earnings, or p/e, ratio) on a company's shares is greater than the after-tax cost of interest paid on extra debt (or the interest received on surplus cash), a buyback will boost earnings per share (EPS).

Say the firm borrows money at an interest rate of 5%. That's 4% after 20% tax. So it could buy its own shares on a p/e of 25 (an earnings yield of 4%) and still boost EPS. Yet a p/e of 25 could never be described as cheap for anything but the fastest-growing company.

So, are there better ways to check how sensible a buyback is? One of the best methods was outlined by fashion chain Next in its 2012 annual report, where it explained how it decides whether to buy back its own shares.

To find out if its money would be better spent on something else, Next works out the equivalent rate of return' (ERR). This is the return Next would need to get on an alternative investment to achieve the same rise in EPS as it would by buying its own shares.

To work out the ERR on a buyback, you need four pieces of data, all of which you can find online: a company's share price; the number of shares in issue; the amount of money to be spent on a buyback; and its latest, or forecast, pre-tax profit. The table below does this for Next.

Next reckons it needs an ERR of at least 8% to justify spending cash on its own shares. As the table shows, at a share price of £62.75, Next's market capitalisation comes to just over £9.7bn. If it uses £300m of its surplus cash to buy the shares at this level, then it will shrink its market cap by 3.08%.

This in turn will boost EPS by a little bit more (3.18% remember, the same amount of profit is now being split among a smaller number of shares).

To raise EPS by the same percentage, without buying back any shares, Next would have to make an extra £23.55m in profit by investing that £300m. However, that's an ERR of just 7.85% slightly below therequired 8%. In other words, Next reckons there are better things it can do with that £300m right now than simply buying back its own shares.

How do other firms stack up?

a fantastic investment

How do other companies stack up? Using Next as a benchmark, we've put several through the ERR test. In the table below, we've looked at what the EPS increase and ERR would be if the shares were bought back at today's share price. We've also worked out what price the shares would have to be to achieve a minimum 8% ERR.

Our conclusion? The buybacks from tobacco firms BATS and Imperial Tobacco look worthwhile, as does broadcaster BSkyB's in all three cases the current share price is well below the level that would represent an 8% ERR. That suggests that their shares represent a decent investment, and could be worth buying for ordinary investors as well.

But Rightmove's buyback looks like a very poor use of the company's surplus cash flow, with an ERR of just 4%, while Compass isn't much better.