On Thursday, Target Corporation announced that its board of directors had authorized a new $5 billion share buyback program. Target would begin repurchasing shares under this new authorization after its current $5 billion buyback program concludes next year.
This comes on the heels of Wednesday’s announcement that Microsoft would be repurchasing up to $40 billion of its own stock.
What exactly is so enticing about stock buybacks for both companies and shareholders? The truth is, stock buybacks are a terrible use of company capital. That’s especially true when a company draws down debt in order to repurchase shares.
The theory behind stock repurchase programs is that the company believes that its stock is undervalued. By repurchasing its own shares in the open market at a value price, the company is able to return those shares to the treasury, and there are fewer shares outstanding.
As we know from simple math, the fewer shares outstanding there are, the more each share is worth in percentage terms to each shareholder.
It obviously stands to reason that the company would want to spend as little money as possible on share buybacks. The preferred language to support stock buybacks is that such behavior “returns capital to shareholders.”
That’s not even true. Paying a dividend returns capital to shareholders.
The problem is that most companies that announce share buybacks have stock that is not even close to being undervalued.
One can define “value” in a number of different ways. If a company believes that its shares are undervalued on a 30-year time horizon, then they can get away with buying back as many of the outstanding shares as they possibly can.
But that’s not a reasonable time horizon when you’re spending billions of dollars in just a couple of years.
The way companies should be evaluating the repurchase program is, at a minimum, determining whether the stock’s price-to-earnings ratio is less than or equal to its growth rate.
That is commonly called the PEG ratio, and legendary value investors like Peter Lynch have set a value of 1.0 for the PEG ratio as being the threshold for value.
Target has a market cap of $55 billion. Its trailing 12-month net income is $3.1 billion. So its current P/E ratio is about 18. Yet analysts estimate five-year annualized growth at only 9%.
That gives Target a PEG ratio of 2.0.
It is thus arguable that the fair value for Target stock is around $53 per share, about half what it is now. So how on earth can Target justify spending $5 billion of shareholder money to buy back stock?
Even worse is that Target is sitting on $10.4 billion of long-term debt. It has $1.6 billion in cash. It generated $2.4 billion in free cash flow last year. So where on earth is this $5 billion to repurchase stock going to come from?
It will come partially from free cash flow and partially from cash on hand. But the rest of it will come from debt. So why are shareholders paying interest on debt to buy back stock?
If the company wants to borrow debt that badly, then it should just pay a dividend to its shareholders. Then they’re at least making good on their promise to return capital to shareholders.
To add insult to injury, Target claims it has a “disciplined and balanced approach to capital deployment” and does so based on a stated set of ranked priorities.
The first priority is to invest in the business in order to keep growing it and maintain current operations. That makes perfect sense.
The second priority is to maintain a “competitive quarterly dividend.” It certainly is paying a dividend, but it could grow that dividend even more. In fact, it should grow that dividend even more because the third priority is “returning excess cash to shareholders by repurchasing shares.”
Once again, excess capital is not being returned to shareholders when stock gets repurchased. That only happens when dividends get paid.
Now, I don’t want to be too hard on Target. I love the company. I love the store. There’s one right around the corner from me and I’m there two or three times a week.
Management has done an extraordinary job of keeping the company, a brick-and-mortar department store at its heart, competitive during a period when Amazon is crushing everyone else.
Management has shown vision and has brilliantly executed its plan to keep Target stores fresh and clean, stocked with quality merchandise at good prices.
Target could easily have stumbled and become a trashy mess like Walmart. The history of American department stores has had many a dark chapter over the past decade. Yet having lived in Los Angeles now for 30 years, I have seen Target constantly reinvent itself and stay relevant.
I just don’t like how Target is choosing to use capital when it has a multi-front war going on in the world of retail.
For investors who are wondering why, despite my argument, companies engage in stock buybacks, here’s the real reason.
By reducing the share count, it allows earnings-per-share to be juiced higher. That’s because the “per share” portion of the “earnings-per-share” fraction gets smaller.
Investors need to know that when they are really digging into the valuation of a company, they have to look at how net income increases each year to find true earnings growth. Then they have to figure out what the true market of the company is, accounting for share repurchases or, on the opposite extreme, the redemption of stock options.
As for Microsoft, the company trades at 23 times trailing 12-month net income of $40 billion (net of net cash on hand). Analysts see five-year annualized earnings growth of 15%.
In this case, there may be an argument to support Microsoft’s repurchasing of shares, even though the stock is at an all-time high. That’s because Microsoft has regained its status as a growth company.
As it is, I award Microsoft a 10% valuation premium based on its world-class brand name, another 10% for its amazing cash flow, and another 10% for the extraordinary amount of cash it has on hand. That alone would justify me paying 20 times earnings for Microsoft.
Yet because it’s a growth company, even Peter Lynch would agree that a PEG ratio for a stock that is considered in the category of “growth at a reasonable price” could be 1.5 or even higher.
Based on my valuation, Microsoft trades at a PEG ratio 1.15. That is arguably a value, and while I’m not thrilled about its decision to buy back stock and would prefer to see a dividend, I’m not torn up about it.
Last modified: September 23, 2020 1:03 PM