As
reported yesterday, the International Business Machines Corp. (IBM) board has
increased the company stock buyback program to a total of $20.6 billion, around
10% of market capitalization (common stock outstanding times market price) at
the time of the announcement. From the
rest of the news coverage, which dubbed this "financial engineering" (as opposed to the enlightened, cutting edge, and totally appropriate financing it really is), MacDougal got to wondering if anybody in the media
had any idea what the announcement meant, and figured it wouldn’t hurt to dig
into that for our valued subscribers, a number of whom are at least as
accomplished in arithmetic as he is.
First
of all, will IBM repurchase 10% of its shares? In that case, intrinsic value,
as measured by whatever relationship to book value you want to use, would rise
by 11.1%. (After subtracting 10%, our
new intrinsic value denominator is to 9 as our old denominator was to 10, and
1/9=11.1%). If you think the market will
let Big Blue pull it off, go ahead and factor that increase into what you've been figuring IBM is worth, and do so today.
Beyond
this, it’s clear that there will be more repurchases if market prices remain low enough. What if IBM were able to
retire 5% of the issue every year? That would
be $10 billion per annum, and the rate isn’t a stretch, given buybacks in
recent years as well as the gloomy global economic outlook, which could put a lid on quotes for a while. Or, what if, which is more likely, Big Blue came up with a way of mixing stock repurchases in with normal bottom line growth, as warranted?
To
get those answers, we peer into the future, focusing on what impact the
new math would have on calculations discounting future earnings per share (EPS) growth. A PE analysis, comparing such a projection with a stock’s ratio of market price to EPS, is
representative of what you’d want to use there, and investors are familiar
with the concept, so lets go with it for our purpose here.
Doing
the grunt work, McDougal found that reducing shares by 5% a year with no
increases at all in annual net income would hike EPS slightly faster than management
could by growing annual net income by 5% per annum without stock repurchases. EPS would double in the 14th year under
such a permanent share repurchase program and increase by eightfold in the 41st
year, versus the 15th and 43d year, respectively, resulting from 5% annual EPS
growth.
Furthermore,
because you buy back fewer shares each year under this program, even with no
net income growth IBM would generate enough cash to purchase 5% of its shares a
year indefinitely as long as the PE ratio remained at, say, 11.5x or lower, a distinct
possibility under the conditions we’re working with. However, were market valuations to improve, Big Blue couldn’t afford to maintain a 5% per repurchase
program if the PE rose too high, and it looks like that point would be reached somewhere before the PE hit 15.
Interestingly,
the PE relationships wouldn’t change a whole lot if IBM were to do both, that
is, grow EPS at 5% and repurchase 5% of its shares every year, but EPS would double
in the 7th year under that assumption, reflecting a 10.5% annual growth rate. Higher earnings growth would have to
eventually increase the PE multiple, the market driving IBM’s PE through 15 at some point. Given management’s firm
commitment to "financial engineering", stock buybacks would probably continue at
an appropriately reduced level in that event.
So,
subscribers, change your valuations accordingly, upping the intrinsic and
adding your annual stock repurchase estimates directly in with net income
growth projections - for as long as IBM’s PE multiple hangs in at current levels. If the price shoots up, wait to hear what the
Board has to say, and recalculate.
It's noteworthy that MacDougal made no provision for an earnings dip in his assumptions, so within the constraints of his work, stock repurchases appear to establish a floor for EPS growth of 5% a year. If earnings were to show signs of chronic decline, that outlook would have to be cranked in anew.
