Chuz, I'm all in favor of stock buy backs, in part because of the tax benefits you mention. I can't agree though that just because the number of shares declines, EPS will necessarily rise. Whether EPS will rise, I would argue, depends on two things: (1) the rate of interest, and (2)the firm's current P/E ratio.
When Dell uses cash to purchase its own stock, it incurs an opportunity cost. This is the interest it could have earned on the cash. Let's assume the rate of interest is 5%. If we assume Dell is taxed at .35, its after tax return is 3.25%. Now, if we assume Dell's P/E is 50/1, it means EPS as a percent of the stock price is 2%. Under these circumstances, the after tax return on cash is higher than the average return on Dell's invested capital, and thereby raises the overall average. If Dell spends cash on a stock buy back, the loss of interest will reduce the average EPS to below 2%.
I'm not suggesting the stock buy back is bad policy, I'm simply noting that it doesn't necessarily raise EPS. EPS will rise iff the E/P ratio exceeds the after tax rate of interest.
JMO
Geoff |
