A worthy discussion topic.
What should we do about stock buy back?
Really affects Cisco, for example. They have been aggressively buying back stock recently. In fact, every dime of profit has been sucked up by stock buy backs.
Start with a thought experiment.
Let's say we have a company with 100 shares worth $10 each on the basis of $1,000 of immutable undepreciating assets.
Let's assume that this company is highly speculative in nature, so the stock price is highly volatile, but on average it goes nowhere. Oscillating wildly about $10.00 per share.
Let's also assume that the company generates Free Cash Flow (earnings + depreciation - capex) of $10.00 per year total ($0.10/share). They issue stock options, two per year, which employees exercise for $5.00 strike price. Every year. And they spend $20 per year buying back two shares per year.
These numbers might have difficulty occurring together so conveniently in real life, but they serve to illustrate a point.
If we go out 30 years using a discount rate of 6%, we would compute a discounted free cash flow of $1,500 (approximately).
Now, are shareholders better off by $1,500? No. Every dime of strike price and every dime of income was soaked up in combating dilution.
The assets of the company won't have grown at all, the shares won't have changed, so shareholders have not increased or decreased wealth. Despite all that free cash flow that was generated.
In the absence of equity financing, Free Cash Flow is an excellent proxy for the current wealth being generated by the business. Equity financing muddies the water.
John |
