Monster Beverage Corp., (MNST) stock was brought to my attention yesterday as a potential investment due to its fast growth and increased share buyback program. I am going to take this stock as an example to illustrate why company management is often misguided when they buy back their own stock.
Stock Buybacks can Destroy Value
If you are a shareholder, you generally welcome any share repurchase announcement. The math is simple, you think.
If the company remains valued at the same level in the market, the less number of shares this value is divided by, the more the value of the remaining shares. It is a way of engineering a higher share price.
What most investors forget to take into account is that the company is using its own cash up to buy these shares back.
These shares do not magically disappear.
So while the numbers of shares do decline, the intrinsic value of the company also declines.
And not to mention any returns that the company could have generated if it had used that cash in alternative projects.
They are Not Always the Best Use of Cash
A shareholder should demand that the company they have entrusted their capital to uses it wisely. This means investing each dollar in projects that maximize the return on the capital.
When a company decides to buyback their own shares, they are indicating that the valuation is so distressed that investing in own shares are likely to generate better returns for the company (and the shareholders), then pursuing any other projects in their normal course of business.
They better be certain that the stock is undervalued by the market.
And they also need to be certain that there are no other better opportunities to use their cash.
There is no point paying $1.50 or $2 for an asset that is worth just a dollar.
You are better off parking the excess cash in treasuries and your shareholders will be richer for it.
Monster Is Going to Overpay for its Own Stock
Monster stock sells at a Price/Earnings multiple of almost 33 and a Price to Book ratio of 8.7. The P/S ratio is over 5. Not exactly in the value territory.
Put it another way, an investor looking to invest in MNST today is looking at an earnings yield of 3%. To point out my obvious problem with this, it indicates that equity in Monster is less risky (due to the perceived and hoped for growth, no doubt) then the AAA rated Microsoft corporate bonds maturing on Oct 1, 2040 that currently yield 3.961%
Maybe energy drinks are the future and more important for the humanity then a company that creates software and systems that power most of world’s governments and businesses.
I doubt it.
The growth argument does not hold water either. If the company expects a continued double digit growth, there is no reason for it to invest in its stock yielding so little. It should invest in growing its business.
You may well ask if a company has excess cash that it doesn’t need, why they should not return it to the shareholders?
Fair question. The company does have $870 m in cash and generates more free cash every quarter. If they want to return a part of this to the shareholders (the stock buy back authorization is for $500 million), all the power to them.
Just pay dividends, regular or a special one time dividend.
It is a fair 1-1 exchange. Every $ in dividend payment transfers the same $ in value to the shareholders.
Income Taxes Should have Nothing to Do with Buyback vs Dividends Decision
The argument about the income tax treatment of the return of capital is something the company should not concern itself about. If that is the argument here, the tax impact is still much lower than the value destruction in buying back an overvalued stock (assuming a 10% incremental tax impact on capital gains vs dividend taxes, the over valuation in this case is comfortably more than 10%). The fact is, most investors have their own tax plans, and quite a few own shares in their tax deferred plans where the tax argument has no merit.
A Lot of Other Companies Make this Mistake
The fact is, top management of a company is not impartial. They always overestimate the future prospects of their company and generally tend to believe that their stock is undervalued, at any price. Worse, a company maybe under a mistaken belief that their mandate is to support the stock price and not growing shareholder value
It all boils down to whether the management is short term focused or is looking after shareholder’s interest for the long term.
Bottomline: Look at Share Repurchases with a Critical Eye
Share repurchases can create value or they can destroy value. They are a great leveler and act as a catalyst to propel the stock price to the true value in the market. If the stock is currently undervalued, it means it will see an appreciation. If the stock is currently over valued, it will eventually decline as the value destruction becomes clear subsequent to the ill-advised stock buy back.
In any case, they also indicate if the management is fully grounded or if they have lost touch with reality.
(In case you are still wondering what my opinion is about investing in MNST, don’t do it)
I agree; buybacks are overrated and overused. However, I do think that company should consider the fact dividends are taxed. If a company with excess cash can buy $1 worth of assets for $1 or less then it may be to the advantage of the shareholder to do a buy back. Buybacks should ONLY be done when the valuation of a stock is depressed below it’s intrinsic value.
 @AAAMPblog Management’s perspective of the intrinsic value is often not objective so they make sub optimal decisions. We will disagree on considering the dividend taxes but that is alright
@arohan Rio Tinto bought back millions of shares at over £ 4-4.4 and the price today is £3.05(been as low as £2.75).Go figure !!!
@simbamara I think companies that have their profitability tied to the commodity markets should just stick to paying dividends
@simbamara They are typically flush with cash when the commodities are high and their stock price is inflated
@arohan I have recent examples of companies issuing bonds(borrowing from market)while continuing to buy back shares !!!!!
@simbamara Sometimes this can be a way of recapitalizing the company (changing debt-equity ratio) since debt is cheaper financing
@simbamara And it could be fine if the buy backs are done at a reasonable price and the company is not already highly leveraged
@arohan Of course if the share price is clearly undervalued,buy back is an option,as often co’s do not have a clue how to invest excess cash
@arohan Sceptics would also say share buybacks are managements way of enhancing their bonuses.
@simbamara Anil, the sceptics would be right in many cases
@arohan Non Executive board ignores this aspect as they are in it for their own bit of bone.Screw the ordinary shareholder !!
@simbamara True, but shareholders are also complicit in this since very few raise an eyebrow when share buybacks are announced
@simbamara The problem is that majority of the voting stock is held by “non-voting” institutions such as mutual funds
@simbamara A widely held stock can be majority owned by various index funds that care even less about shareholder issues
@arohan Shareholders are lethargic+even if active,unless the institutions support them(who play golf with management:)),they cannot do much.
@arohan Exactly,as they are all in the same racket !!
@simbamara
Shareholder control has absolutely weakened as passive fund investing grew in popularity
@arohan Tax on dividends argument is not full proof.Lot of non tax paying pensioners+funds depend on dividend income for their survival.
@simbamara I think the argument should not even exist for the management. Shareholders do their own asset plans based on their situations
Excellent post, I sometimes wonder if companies are looking to get favorable press by doing these buybacks vs. focusing on what I consider to be the job of any public company’s management, building long-term shareholder value/wealth.
 @rwohlner Roger, you may be right. Sometimes, it may just be doing it for the sake of doing something. A better signal to the market would be if these buybacks are accompanied by insiders buying in the open market in their own accounts. Thanks for dropping in
This type of buyback is akin to a central bank buying its’ own currency just to prevent it from devaluing too quickly, and there is no logical reason to do so. You made an excellent point when you point out this stock is overvalued, and therefore, it would not be in the best of management, or the shareholders for the company to utilize cash in such a frivolous manner. The Price/Sales and Price/Book are very high relative to other stocks in the market.
http://finance.yahoo.com/q/ks?s=MNST+Key+Statistics It would have to drop to about $20/share before I would consider investing in it. Â Even in its’ industry, this stock is trading at a premium.
http://financials.morningstar.com/valuation/price-ratio.html?t=MNST®ion=USA&culture=en-US If you look at the valuation metrics, this stock isn’t worth owning right now. Â EPS is $0.62/share compared to $0.48/share a year ago in Quarter 2. Â This represents a 29.2% increase over a year. Â The management isn’t clearly concerned about the shareholders, judging from their lack of judgment by buying back their own shares when they’re overvalued. If they want to buy back their own shares, management should wait until the shares become more reasonably priced.Â
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 @pbanik Paul, you make an excellent analogy between this and propping up a currency. Ultimately, it is the fundamentals that support the valuation and most of the times the management is better off controlling what they should, viz. the fundamentals. Share repurchases make sense on only rare occasions.
 @ShaileshKumar I agree Shailesh. I think it makes sense if the management is trying to increase value for shareholders, or management is buying the shares at a discount to its’ true value.
@minedah Thank You Amin for the tweet! Hope you waited on the Facebook stock. Still expensive (via commun.it)
@irondragonfly8 I prefer dividends but buybacks can be nice for companies with consistentcy which sadfly Best Buy doesnt have
@AAAMPblog Thank you for the tweet! Really appreciate it
An article by the WSJ quickly proves this point with an article on BBY, aptly named: Best Buy’s Buybacks Haven’t Always Been Best Idea (http://blogs.wsj.com/deals/2012/08/22/best-buys-buybacks-havent-always-been-best-idea/) which Jim Cramer humoured that the company “bought a hundred million shares of itself at a very high price and now doesn’t want to buy any more down here” (episode 08/21/12) which as of that recording slumped to -33% off its YTD high of ~$28.
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As @arohan stated, the better signal to buybacks is from signals from management that they have conviction in their company and buy shares in the open market. Looking at Form 4s, the only buy that was made was by the director on August 15, with 88 shares! (http://www.sec.gov/Archives/edgar/data/865752/000114036112037486/xslF345X03/doc1.xml) The buy before this was August 19 2011, with the amount of 33 shares. Between those two transactions, shares have been sold in the open market with the #shares ranging from 4 digit sizes to 8 digit sizes; don’t forget I’m referring to share quantity not value! I know there are many factors to consider than the black and white facts of buying and selling shares in the open market but I’m using it for the purpose of my argument.
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To further prove the point against stock buybacks, which as a dividend seeker I am not a fan of, is in Aswath Damodaran’s “Value Investing: Investing for Grown Ups?” (http://pages.stern.nyu.edu/~adamodar/pdfiles/invphiloh/valinv.pdf?q=value) on page 47, where he charts the stock buybacks and dividends of US firms between 1989-2010, the highest amount of buybacks were made in 2007 and were increasing yearly up until that year where stock prices and valuations were at their highest and after the credit crisis in 2009, buybacks were a fifth of the 2007 high. I need not explain further.
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On the contrary, to support @AAAMPblog’s argument that buybacks should only be done when the valuation of stock is depressed with an example, a company that is executing the buyback program right is AIG which is buying back shares at 40% discount to their book value (http://www.thestreet.com/story/11679363/1/johnson-swinging-away-at-aig.html).
 @MikeTsangaris  @arohan  @AAAMPblog Mike, great references. I just had a great conversation with some one where I made a point that insiders may have a slight information edge over the rest of us on purchasing their own stock (on personal accounts), but even then you have to be careful to remove the biases they might have. It is a signal to support your thesis, but nothing more and should never become a key basis for your investment thesis.
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Re stock buybacks, I am appreciative of all the comments this post has received and it looks like many of us have long suspected that in many cases stock buybacks are more of a PR tool than a tool to enhance shareholder value. There are legitimate uses of buybacks but to my dismay the companies that do it right are exceptions rather than the rule.
I invest to stock for about 8 years,the 1st time to hear about this,thx for you sharing.