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Tuesday, 5 January 2016

My (brief) thought on Share buy backs!


One of my favorite JSE listed companies, Brimstone Investment Corporation (JSE:BRN) has just repurchased about 4 million of its ordinary shares at a cost of about R51.3m and at an average cost price of R12.98 per share. Are its shares undervalued? I think so. I have been keeping my eye on its share price for the past couple of months now - continuing to accumulate as much i can for the next few months. I think this BEE company has some great management with favourable long term prospects ahead.
The goal of a companies management is to maximize its return for shareholders and a share buyback generally increases shareholder value.
A share buyback, also known as a "share repurchase", is when a company buys back its shares from the marketplace. You can think of a buyback as a company investing in itself, or using its cash to buy its own shares.
The idea is fairly simple: because a company can't act as its own shareholder, repurchased shares are absorbed by the company, and the number of outstanding shares on the market is reduced. When this happens, the relative ownership stake of each investor increases because there are fewer shares, or claims on the earnings of the company.
Sometimes management may feel the market has discounted its share price too steeply so buybacks of shares is the best strategy for companies to employ when the current share price is less than the calculated fair value of the share in question.
During market downturns, such as in a recession, an opportunity may arise for companies to purchase some of their own shares and cancel them, hence reducing the overall number of shares on issue.
The effect of less shares means that the future earnings per share is likely to increase. The company share price can fall in the market for many reasons like weaker-than-expected earnings results, an accounting scandal or just a poor overall economic climate. Thus, when a company spends millions of Rands buying up its own shares, it says management believes that the market has gone too far in discounting the shares which is a positive sign.
Suppose a company repurchases one million shares at R15 per share for a total cash outlay of R15 million. Below see the change as a result of the buyback.


Before BuyBack
After BuyBack
CASH
R20m
R5m
ASSETS
R50m
R35m
EARNINGS
R2m
R2m
SHARES OUTSTANDING
10 million
9 million
ROA
4%
5.71%
EPS (Earnings per Share)
R0.20
R0.22




As you can see, the company's cash has been reduced from R20 million to R5 million. Because cash is an asset, this will lower the total assets of the company from R50 million to R35 million. This then leads to an increase in its ROA, even though earnings have not changed. Prior to the buyback, its ROA was 4% (R2 million/R50 million) but after the repurchase, ROA increases to 5.71% (R2 million/R35 million). A similar effect can be seen in the EPS number, which increases from 20 cents (R2 million/10 million shares) to 22 cents (R2 million/9 million shares).
The buyback also helps to improve the company's price-earnings ratio (P/E). The P/E ratio is one of the most well-known and often-used measures of value. When it comes to the P/E ratio, the market often thinks lower is better. Therefore, if we assume that the shares remain at R15, the P/E ratio before the buyback is 75 (R15/20 cents); after the buyback, the P/E decreases to 68 (R15/22 cents) due to the reduction in outstanding shares. In other words, fewer shares + same earnings = higher EPS!
Based on the P/E ratio as a measure of value, the company is now less expensive than it was prior to the repurchase despite the fact there was no change in earnings.
From a shareholder’s point of view, I try to make a judgement as to whether the company's offer to purchase their own shares is a sensible move by comparing their buying price to my estimate of fair value - that is, what I would pay for the share from a value investing perspective.
So depending on the price at which the offer is made, share buyback programs may be a good thing, or not-so-good thing for a value investor.

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