Although there are a plethora of stock valuation techniques, I prefer the use of factors, such as small capitalization, value, profitability and momentum, which have been shown to drive superior risk-adjusted returns for stocks over long periods of time. On the other hand, I also hold in high esteem Warren Buffett’s focus on “wonderful companies” with significant cash flow and economic moats. As a result, the companies that I research tend to have tremendous excess cash flow, and many of them return that cash to shareholders directly in the form of dividends, or indirectly in the form of stock buybacks. What companies do with that cash is ultimately a key driver of their success, and it is also the final determinate of whether I want to become an owner of that company.
Last week, Microsoft (MSFT) announced a $40 billion stock buyback program, which is about 9% of its outstanding stock at the current price. It will commence at the beginning of 2017 after completing MSFT’s prior $40 billion stock buyback program. In addition, MSFT announced a comparatively small 8% dividend increase, or $0.03/share per quarter, which adds up to $600 million per year of additional dividend payments.
Why is MSFT starting another huge buyback program instead of increasing its dividend more? Here are a few reasons:
- Many investors rely on the income stream of dividend paying stocks, and so when a company reduces its dividend, the stock’s price usually gets hammered. By keeping the dividend increases reasonable, the company reduces the chances that it will have to cut the dividend in the future.
- While dividends are consistently paid, a stock buyback plan can be instituted periodically, stopped without as many repercussions, and spread out over long periods of time.
- Stock buybacks are not taxable to all shareholders, but rather only to the ones who choose to sell. Yet stock buybacks arguably benefit all shareholders because there are fewer shares available and therefore the price of the remaining shares should increase. Dividends are taxable to all shareholders unless the stock is held in a tax-advantaged account.
- Stock buybacks, by reducing the number of outstanding shares of the company, increase the Company’s earnings per share and reduce the price-to-earnings and price-to-book ratios, among other things, arguably making the stock a better value. It further reduces the cost of the dividend going forward because there are fewer shares entitled to it.
Stock buybacks have some prominent weaknesses as well. One is that they are a form of financial engineering, as a company could have a declining financial situation masked by stock buybacks, which make the company look more successful on a per-share basis. Another is that stock buybacks are often poorly timed, which is extremely important. I’ve written amount dynamic cash allocation for individuals, and the same thing applies to companies. They need to look at their excess cash flow and determine what is the best use of that cash, not just based on their options at the present time, but also based on their expected options over the next few years.
As it relates to MSFT, let’s assume that interest rates are low (on both debt and savings), all high-yielding projects are amply funded, and there is plenty of cash saved for anticipated future high-yielding projects. It doesn’t make sense to continue saving cash, or paying down extremely low interest rate debt, and so the company wants to return its excess cash to its shareholders. A huge dividend increase is not desirable because of concerns that it could not be sustained through an economic downturn.
The remaining options are stock buybacks and special dividends. If the stock is clearly undervalued, then I am in favor of stock buybacks; however, if the stock is fairly valued or overvalued, then I would strongly prefer a special dividend. A special dividend is 100% cash in my pocket, potentially non-taxable or tax-deferred depending on the account involved. I can then spend that cash or put it to work buying more MSFT stock or stock of another company. A stock buyback should, in theory, improve the stock’s price, but that only helps me when I sell the stock, and there is no guaranty that the return (i.e. price increase) on MSFT’s investment, in the form of stock buybacks, is going to be sufficient compared to the other available options.
There is ample research that companies are quite poor at timing their stock buybacks (here’s a second article). One reason is that companies have the most excess cash flow in good economic conditions, which also happens to be when stocks are more likely to be overvalued. Another is that management is often compensated based on metrics such as earnings-per-share, and managers frequently hold significant stock options, so stock buybacks help increase their wealth. When a company’s stock price is significantly overvalued, rather than buy the stock back, the company should consider issuing it to raise cash, repay debt, or for acquisitions, assuming that there are high-yielding opportunities now or expected in the near future. Some companies are very willing to do this, whereas others buy back their stock all the time, every year, whether it makes sense or not.
What concerns me about MSFT’s buyback is that MSFT’s stock is fairly valued at best. My conservative discounted cash flow valuation puts the stock at 57.50, which is about where it is trading now. Morningstar has it valued about 10% higher, but comparing its P/E, P/B, P/S, P/CF and dividend yield to the past five years indicates that the stock may be as much as 30% overvalued. Regardless, MSFT’s stock is not a steal right now, and so this is not a great time for it to spend billions buying back its own stock. As an example of a good stock repurchase strategy, Warren Buffett has stated on multiple occasions that his company, Berkshire Hathaway, would repurchase its own stock if its stock price fell below 1.2 times book value. Hopefully, MSFT has a stock price in mind (ideally $50 or less) or a objective metric such as P/E or P/B, below which it will start repurchasing its own stock. If that is the case, then I would feel more comfortable that MSFT is properly utilizing this cash.
Disclosure: Christy or I own MSFT stock. We do not intend to make any purchases of MSFT stock in the next 48 hours.