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Monster Beverage Corp., (MNST) stock was brought to my attention as a potential investment due to its fast growth and increased share buy back program. I am going to take this stock as an example to illustrate why company management is often misguided when they repurchase 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.
Why do Companies Buy Back Stock if 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 buy back their own stock, 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. The problem is, that the company and the management often have an inflated sense of their worth.
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.
See also: share warrant meaning
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 (stock book). 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.
See: commodities stocks
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.