Minyan Mailbag: Dividends and Buybacks
The growth of earnings that comes from issuing debt and buying back stock is not sustainable.
This mailbag is in repsonse to my Nov. 4 article on Buybacks and Dividends.
Good stuff as always!...
A minor point... near the end you say you object to a company leveraging its balance sheet to do buybacks. But technically, isn't paying out cash for a buyback changing (negatively) the balance sheet even if no borrowing is involved? In other words, you buy back stock and cash becomes a smaller part of total assets and overall shareholder equity shrinks. The enterprise now IS at more risk (smaller and less cash) than before, although admittedly not as seriously as one that takes on debt to buy back stock. Isn't it just a matter of degree, rather than a sharp difference??
Fully agree that buybacks are better and healthy dividends are second best, since management definitely does have their flights of egoistic fantasy and do some really dumb things in the name of growth.
Don, as always, great point!
So let me clarify that: Buying back stock is leveraging any way you look at it, because it lowers equity (cash balance declines - lowers equity and thus debt to total assets ratios rises) - it's hard to argue with that. Also, with this logic, paying a dividend is leveraging as well, as it forces cash balances to decline.
However, the distinction I am making is that when a company increases debt (HIGH leverage scenario) - in absolute terms, by issuing debt to buy back stock, a company can only do so much of that because it has a finite borrowing capacity. Thus the growth of earnings that comes from issuing debt and buying back stock is not sustainable. Where stock buybacks that are sourced from free cash flows (LOWER debt scenario) result in a more sustainable earnings growth and arguably less risky (everything held constant), as they don't raise the absolute levels of debt. As long as free cash flows keep rolling, a company can keep buying stock.
From a credit analysis perspective, HIGH leverage scenario case does the following: raises debt to assets ratio and lowers interest coverage ratios; LOWER leverage scenario case does the following: raises debt to assets (but by lower degree than in first case) and has no impact on interest coverage ratios (alright, it has a very small negative impact as cash paid out earns interest).
Good points; all agreed and understood... but even if the buybacks come from free cash flow (definitely the preferred scenario) they by nature reduce the financial robustness of the company from what it WOULD have been in their absence.
Agree, but at a certain point cash sitting on balance sheet just takes away value (i.e. MSFT) - but your point is well taken.
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