To Chuz - subj: how do stock buy-backs impact EPS
(with full apologies to Voltaire <gg>)
When a firm engages in a repurchase of shares, what happens to its EPS? I submit the answer depends on the firm's p/e ratio. If the stock sports a high multiple, a buy-back will cause EPS to fall, and if the stock carries a low multiple then the buy back will raise EPS.
Here is a simple arithmetic example. Suppose a firm has $100 MM assets, consisting of $80 MM non-cash assets and $20 MM cash. Let's assume there are 1 MM s/o. The market price/sh. = $100. Let's assume the stock carries a p/e = 50/1. These figures imply that the firm's total earnings are $2 MM. The firm's EPS can be calculated as $2 MM / 1 MM shares = $2.
Now suppose the firm spends all its cash reserves on a buy-back, repurchasing 200,000 sh. If we assume the risk-free rate of interest is .05, the firm's interest income will fall by $1 MM. This means the revised EPS will be $1 MM / 0.8 MM sh. = $1.25 per sh. In this example the share buy back causes EPS to decline by 37.5%. A similar example can be constructed to show that a low p/e stock would experience a rise in EPS.
A share repurchase is not a free lunch for the firm. When the firm spends cash to repurchase shares, it gives up the interest that cash could otherwise have earned. So a buy back has two effects: (1)fewer shares outstanding, and (2)lower total earnings. What happens to EPS depends on the firm's p/e and how it compares to 1/r, where r is the rate of interest. If p/e > 1/r, the buy back will cause EPS to fall, and if p/e < 1/r, the opposite will be true. If p/e = 1/r, the buy back will leave EPS unaffected.
The fact that EPS may decline in a buy back isn't the whole story. If a high p/e stock is receiving a lot of interest income from cash reserves, that acts as a drag on its future earnings growth rate. If the firm throws off the cash, its EPS will grow faster, albeit starting from a new, lower figure.
Geoff |
