A lot of people talk about buyback yield or total shareholder yield or something

like that as amount spent on buybacks/market cap equal buyback yield. In the
next couple paragraphs, Ill lay out the basics of how you can decide whether a
buyback is big or small, good or bad. Then Ill spend the next 6,000 words way
more than most people need to read getting into the nitty gritty of exactly how
you can calculate the buyback yield and even more importantly how you can
calculate a companys return on its buyback. This is important stuff for buyback
obsessed investors people like me and Warren Buffett. But it is much more
than most investors need to know.
One principle to keep in mind is asset-earnings equivalence. An asset is not just
worth what it appears as an asset to be worth. An asset is worth its future
earnings. If a company pays a $1 dividend, that dividend is taxed and reduced to
at least 85 cents. In cases where using $1 to buy a stock only gets you 85 cents
of intrinsic value, the dividend payment still makes more sense. In cases where a
stock is at least as good a purchase as the rest of the market, a buyback rather
than a dividend can create value. It is not unusual for $1 spent on a buyback to
be worth more than $1.25 in dividend form. It happens all the time. For example,
if a stock buyback is both not taxed and is used to buy back stock at a discount
of at least 10% of intrinsic value it will always create at least $1.25 in value
versus a $1 cash dividend. Thats because a $1 buyback done at 90 cents on the
(intrinsic value) dollar creates 11 cents of value, while a dividend destroys 15
cents of value. This is the critical concept to keep in mind whenever you think
about buybacks. It works in reverse too. Once a stock is 20% overvalued, the tax
benefits of a buyback versus a dividend are insufficient to overcome the loss
created by paying $1.20 to get only $1 of intrinsic value. At this point, buybacks
start to destroy value.
If we look at a case like Berkshire Hathaway (BRK.A)(BRK.B) where I believe
the stock is trading at 80 cents on the intrinsic value dollar a buyback creates a
lot of value. In fact, a buyback is almost 50% more effective in returning value to
Berkshire shareholders at todays price than a dividend would be. Thats
because $1 spent on a buyback buys $1.25 of intrinsic value. Meanwhile, $1 paid
out in dividends becomes no more than 85 cents after-tax.
Of course, the buyback does not eliminate the tax. It only defers it. But very longtime holders can get enormous benefits from such buybacks.
We should be careful to overstate the tax aspect of buybacks. For example, QLogic has a lot of cash overseas (almost all of its $500 million). The company
could in theory make several tender offers for close to 50% of its market cap
with that cash. This is the Teledyne (TDY) approach. Q-Logic doesnt do that for
several reasons. One, it likes having some cash on hand at all time. But, more

importantly, it doesnt want to pay the tax.

The actual intrinsic value math here does not support the companys position. No
one is complaining because Q-Logic already buys back a lot of stock. But, even
paying an extra 35% tax (the most possible) on bringing back cash to the U.S. to
buy stock would not destroy value. Thats true because the stock is so cheap that
a buyback at around todays prices would result in anywhere from an 8% to 15%
return on the cash used to make that buyback. This is higher than shareholders
can make on their own. The companys argument for keeping the cash is valid
only if they can find a way to earn more than 8% a year overseas. Perhaps they
can. But it seems more like a knee jerk desire to avoid taxes rather than a careful
look at how much value could be created even after paying taxes versus keeping
cash idle.
These are the kinds of complexities you deal with when you start talking about
stock buybacks. You need to think about the buyback yield, the taxes that would
be paid (or not paid versus dividends), and the return the company would get on
the buyback.
Companies rarely talk about the return on their buyback. But that is a critical
element of the decision to buyback stock sense the higher the price at which
stock is bought back the less the intrinsic value of the capital returned to
shareholders and the lower the stock price at which the buyback is done the
more intrinsic value is created. It is never a 1 to 1 comparison between a dollar of
buybacks in price terms leading to a dollar of buybacks in value terms. They are
always different.
But there are two parts that matter when looking at the difference between a
stocks buyback yield and its dividend yield. A dividend yield is simply the stocks
annual dividend per share divided by the stock price. Keep in mind, dividends are
taxed. So, a 6% dividend yield is only worth about 5% after-tax in the best
circumstances.
The value of a buyback is more complicated. The tax is deferred for now but
the value added or destroyed relative to a dividend payment depends on the
return the company is getting on its buyback versus the return you could get by
going out an buying another stock. For example, if a company with a P/E of 10 is
buying back its stock, that company is probably going to earn at least 10% a year
on its purchase. It is unlikely to can buy stocks for yourself right now that return
11.75% which is what you would need to offset a 15% dividend tax and earn what
the company can earn through a buyback.
A simple rule of thumb is that when a companys stock price is below the P/E at

which you could buy other stocks, a buyback probably helps you. When a
companys stock price is above the P/E at which you could buy other equally
good stocks, youd probably be better off with a dividend. When the stocks P/E
is close to the P/E you would pay for other stocks its probably better to have a
buyback because:
1. You dont have to pay an extra tax right now
2. You already know you like this particular stock. Thats why you already own it.
Thats the simple way to think about buybacks. Now, lets get into exactly how
you can calculate a stocks buyback yield and a stocks return on that buyback.
Both numbers matter. A high buyback yield with a low return on that buyback is
not good. In that case, a dividend would be better. Meanwhile, a low buyback
yield with a high return on the buyback is good but it means you are either
paying too high a price for the stock, or the company isnt buying back enough
stock.
Ill focus on a particularly interesting case here: Q-Logic (QLGC). Q-Logic has a
high buyback yield (around 12%). And it has a very, very high return on its
buyback (about 25%). However, there is a complication with Q-Logic. It is using
what I call anti-leverage. This makes the buyback less effective because its
actually much smaller than it first appears to be.
What they seem to be using is the cash spent on buybacks last year divided by
today's market cap. That's what I see most often. So, assume a company - we'll
use Q-Logic who pays no dividend but does buyback stock - spent $127 million
buying back stock last year. In fact, they actually did spend $127 million buying
back stock (as you can see on their 2012 cash flow statement for the year ended
April 2012). The company's market cap is $1.05 billion today. So, a buyback of
$127 million divided by $1.05 billion gives Q-Logic a buyback yield of 12%. In a
sense, that is true. But I would argue it is clearly wrong. Why?
Because Q-Logic spent $127 million gross on share buybacks. It did not spend
$127 million net. The company also issued stock. We need to adjust for that. The
company issued $30 million of stock last year and bought back $127 million. So,
the net buyback was $97 million. That leads to a buyback yield of 9.24% on
today's market cap of $1.05 billion. That number is probably about right as a
backward looking number.
A buyback is effectively a free cash flow type number. In no sense is a company
required to have earned its buyback in GAAP income. The same is theoretically
true of dividends - but rather rare. I have seen companies pay dividends they did

not earn in GAAP terms but did earn (in their minds) as free cash flow. It's very
rare. And it only happens when a company manages for free cash flow.
Dividends tend to be stated as a percent of income earned, etc.
You want to look back at least three years to get any free cash flow number. Let's
do that for Q-Logic. Their cash flow statement for the fiscal years ended 2012,
2011, and 2010 gives us both the buyback amount and the stock issued amount.
By netting treasury stock purchases (share buybacks) against proceeds from
issuance of common stock and options exercised (stock issuance) we get a net
share repurchase in dollars for each of those three years. They were: $129
million in 2010, $153 million in 2011, and $97 million in 2012. That gives us a
three-year average of $126 million. The market cap right now is $1.05 billion. So,
$126 million divided by $1.05 billion gives a buyback yield of 12%.
Is that right? And if so, is it equivalent to a 12% dividend yield?
I'd say it's pretty much right. In my view, Q-Logic's stock buyback yield - based on
the past record alone - is around 12% on today's price. If the stock stays at the
same price and free cash flow stays at the same level as it has in the past, QLogic will buy back about 12% of its shares over the next year. In that sense, a
new Q-Logic shareholder who buys 1,000 shares of Q-Logic today will - in one
year - be the owner of the equivalent of 1,120 shares of Q-Logic. That's because
the share count will shrink. And this shrinkage will be effectively the same for that
shareholder as if the share count did not shrink but the shareholder was given an
extra 120 shares of Q-Logic at the end of the year. In that sense, it's exactly like
a 12% cash dividend being paid in stock rather than cash to the shareholder.
The actual reality of course is different. What really happens is that the
shareholder's account shows the same number of shares and yet his percentage
ownership of the company rises. What's important to take away here is that 12%
of his original purchase price was generated in free cash flow and that 12% was
reinvested in the company's stock. He did not receive cash. And he did not pay
taxes on dividends. Instead, his stake in the company increased and his deferred
gain on the company increased. This means he was able to avoid taxes for now in fact, he can avoid them until the moment he sells since Q-Logic has never paid
a dividend. And he will get long-term capital gain treatment when he does sell.
This is the tax part everyone talks about. The more reliable part of the tax
situation - it's not really an issue that's debated in the U.S. from year to year - is
the deferring of the tax. It's a pretty basic principle that income is taxed when
received but that an increase in market value without any transaction does not
constitute income yet. So, while the favorability or unfavorability of dividends
versus capital gains etc. bounces around over time depending on who is writing
the tax laws - it's unlikely that putting off paying a tax will ever become a

negative.
Okay. Now, the issue is the return on the buyback. This is what you were getting
at. I don't think book value is a good measure for most companies. I think
earnings yield - or free cash flow yield, it depends on the company - is the best
measure for most operating businesses. You can look at the P/E ratio,
EV/EBITDA, Market Cap/Free Cash Flow, and EV/Free Cash Flow as good
indicators of what a company's return on its buyback is.
Here, you want to compare the return on the company's buyback with the return
you could achieve. However, you want to keep in mind that while you would pay
a tax on the dividend the company does not pay a tax on the buyback. Let's say I
imagine John Wiley (JW.A) will get a 10% return on its buyback. Likewise, I
think I can go out and return 10% a year myself picking my own stocks. In this
case, which should I prefer? Should I prefer John Wiley paid a dividend or used
all of its free cash flow to buyback stock?
If my assumptions - that John WIley will get a 10% return on their buyback and I
can make 10% a year picking stocks in my brokerage account - are true, then
John Wiley creates more shareholder value for me when they don't pay a
dividend and instead just buyback stock. In fact, that is the actual case with the
company right now. If anything, I've understated the return JW.A can get buying
back their own stock (it's probably closer to 13% than 10% right now - I'd
estimate 12% to 15% if I had to pick a range) and most investors will have a hard
time earning more than about 7% picking stocks right now. This just goes to
show you that I think John Wiley is - on an admittedly leveraged basis - a cheap
stock.
But, what if the reality was that JW.A really would earn 10% on their buyback and
I really could make 10% picking new stocks?
It doesn't matter. That would still suggest the capital allocation should be 100%
buyback and 0% dividend because even under the best circumstances a
dividend will be taxed at 15%. Under the worst circumstances, it could be almost
40%. But taking the best case of 15%, we see that for every $1 John Wiley pays
me in dividends I only keep 85 cents after-tax. The company however pays no
extra tax on a stock buyback. So, if they earmark $1 for buybacks they actually
buy $1 worth of stock on my behalf. Therefore the choice is - excluding the factor
of timing between when I receive cash and when I pay the IRS - a matter of me
getting to keep 85 cents in cash or $1 in stock. Obviously, if the stock is at all
undervalued, it's better to have the stock.
Let's look at real-life for a John Wiley shareholder. I would estimate the return

you can get by owning more John Wiley stock to be 12% a year. This is based on
a roughly 10% free cash flow yield (which again, is leveraged and assumes JW.A
does not pay down debt over time relative to equity) and a 2% long-term growth
rate. That growth rate is simply an assumption about academic journal pricing. I
expect it to rise over time. Like I said, the reality might be more in the 2% to 5%
annual growth range. But, I am going to assume a 10% free cash flow yield today
plus 2% growth each year forever. Meanwhile, at today's - in my view - high stock
prices I think the average individual investor will have a hard time earning more
than 7% a year in stocks over the next 5 to 15 years.
Assuming a 15% dividend tax, every $1,000 that John Wiley uses to buyback
stock would become $5,474 by the end of a 15-year holding period. If John Wiley
instead paid its shareholder $1,000 in a dividend which the shareholder then put
in an index fund, etc. I would estimate they would have about $2,345 at the end
of 15 years. Therefore, over a 15 year holding period the difference between
John Wiley buying back $1,000 worth of stock on your behalf this year and
paying you $1,000 in a cash dividend is the difference between $5,474 and
$2,345.
In the case of John Wiley - at today's price - I think it is very clear that a long-term
investor would be made much better off through a buyback rather than a
dividend. However, I don't think the market recognizes this. In fact, I think many
investors would prefer seeing a dividend to a buyback. They'd be wrong unless
they can earn a tax equivalent return greater than the company can earn buying
back stock. In the case of John Wiley, shareholders who can earn over 14% a
year in the stock market (or elsewhere) are the only shareholders who should
prefer a dividend to a buyback. I believe there are very, very few John Wiley
shareholders who can make 14% a year on their own long-term - therefore, it
would be to the benefit of almost all long-term shareholders of JW.A to use all
free cash flow to buy back stock rather than paying any dividend.
The argument some will make against a buyback and in favor of a dividend is
that a buyback is essentially a doubling down on the company. That's true. John
Wiley is a higher quality company - with a wider moat - than the S&P generally
and the median hypothetical stock certainly. It's also cheaper right now. So
there's no valid argument against John WIley buying back stock at this time in
favor of paying a dividend.
But what if you had doubts about the long-term viability of the business? (I should
point out, I have no such doubts with John Wiley. The most important part of their
business - academic journal publishing has a durable moat that will be around for
however long you choose to own the stock.)

That is a legitimate concern. But it's a legitimate concern at the corporate capital
allocation level regardless of dividend policy. Charlie Munger has pointed this
out. General Motors ruined its shareholders. Berkshire Hathaway did not.
General Motors was a failing business. Berkshire Hathaway was a failing
business. Neither company could do anything to fix that problem. But only one
company saved its shareholders.
If a company has an at risk business, it can allocate capital to other areas. Many
successful companies no longer engage in the business they started in.
If American Express (AXP) stayed in its original business, it wouldn't be around
today. The same is true of IBM, MMM, and BRK.B. Some companies choose to
pay large dividends or buy back stock while the business is failing rather than
allocating capital into a different industry. Let's look at Value Line (VALU). Over
the last 10 years, Value Line has paid out about 85% of the company's current
market cap. It's a dying business. It had a decision to make. It could allocate
capital to new areas inside the corporation, it could pay dividends, or it could
buyback stock. It chose to pay dividends.
Now, let's compare this to Q-Logic. The company spent about $1.32 billion on
stock buybacks over the last 10 years. The company's market cap today is only
$1.05 billion. So, the company has spent more buying back stock than the
company is worth now. Is that a good outcome or a bad outcome?
It sounds like a pretty terrible outcome.
But there's always the issue of valuation here. Is Q-Logic valued right. Enterprise
value is even lower. It's about $555 million. Of course, when a company buys
back stock - and now we're getting really meta here - it also buys back more of
the cash it keeps. In other words, Q-Logic buying back stock today is not really
valuing its continuing operations at $1.05 billion. It's only assigning them a value
of $555 million. That's because continuing shareholders - those who don't sell
into the buyback - get an increase in the company's free cash flow as well as in
increase in the cash left on the balance sheet after the buyback. Q-Logic may be
spending $11 to buy back a share of stock, but that share they buy back comes
with something like $5 of added cash attached. So, if you start out as a
shareholder of 1,000 shares of Q-Logic you end the year with a greater
ownership in Q-Logic's ongoing business plus an effective "cash back" on the
stock repurchased. Basically, if Q-Logic pays $11 for stock right now, it's paying
$11 and then getting $5 back. The reverse is true for a company like John Wiley
that uses debt - they effectively increase debt as they buy back stock because
they decrease cash relative to debt. This isn't necessarily negative - in fact, this
leveraging is a reason why buybacks work over time - but it's making a clear
decision to avoid paying down debt and instead buying back stock. It's an active

choice not to deleverage.

Q-Logic already uses "anti-leverage". Their return on equity is lower than their
return on invested capital because much of the shareholder equity is not invested
in the business. Shareholder's equity is $716 million and $115 million of that is
goodwill. So, tangible equity is $601 million. However, the company has $495
million in net cash. So, unleveraged tangible equity would be only $106 million.
That's the part they are using in the business. Obviously, Q-Logic's returns on
invested capital are extraordinarily high. In fact, the numbers they report in ROE
etc. are still acceptable looking despite Q-Logic using a huge amount of "antileverage". They only have $106 million in tangible net worth tied up in the
business and yet the balance sheet has $601 million in tangible shareholder's
equity. That's equivalent to having a "leverage ratio" of 0.18. Obviously, a 100%
buyer of Q-Logic would simply remove the $495 million in cash - it's overseas
and will have to be taxed if brought to the U.S. - and keep only the $106 million in
tangible equity that is tied up in the business.
And this is where we get to a really important concept. Let's imagine Q-Logic is on average - buying back about $126 million worth of stock. What is the return on
this repurchase?
Let's start by assuming future earning power is simply Q-Logic's 10-year average
free cash flow. Average free cash flow over the last decade has been $141
million a year. The company's market cap today is $1.05 billion. So, the return on
repurchase under those circumstances (assuming neither earnings growth or
decay) would be 13.4%. But there's a problem here. The company's enterprise
value is not $1.05 billion. It's $555 million. So, if Q-Logic were really delivering
free cash flow of $141 million a year - that free cash flow only costs the company
$555 million to buy (you don't pay for the cash you keep on the balance sheet it's still there, in fact in a higher proportion for continuing shareholders).
So, isn't the real return on repurchase more like $141 million / $555 million =
25.4%.
Yes, it is. Q-Logic is earning about a 25% on its repurchase. However - and this
is critical - the repurchase is not as large as it appears. If Q-Logic spends $126
million this year to buy back stock, it's not actually buying back as much of the
operating business as it would be if the company was not anti-leveraged.
Basically, about 47 cents of every dollar Q-Logic spends on repurchases is going
to actually buy back the company's operations. The other 53% is just being
refunded in surplus cash. I know that's a confusing concept. But it's important. QLogic has no method for focusing buybacks only on the operating business the
way a 100% private buyer could do. If you buy back stock in the open market you

get more ownership of the income/cash flow statement and more ownership of
the balance sheet.
So, really what's happening when Q-Logic buys back stock?
Well, they earmark $126 million - again, this is just a three-year average of what
they've actually spent buying back stock - for buybacks. However, only $59
million of this is being used to buyback the operating business at an enterprise
value of $555 million. So, they are buying back about 10.6% of the operating
business when they spend $126 million. The remainder of that $126 million about $67 million - is just swapping cash for cash. This is a very important
concept. And it has major implications for stockpicking. It is actually possible for
John Wiley - which trades at twice the EV/EBITDA of Q-Logic - to buy back
roughly the same amount of the operating business each year (around 10%) as
Q-Logic is doing despite Q-Logic having much higher cash flow relative to
enterprise value. How is that possible?
Leverage.
The ability of a company to increase earning power through buybacks depends
on the percentage of shares it buys back. For example, Q-Logic can buy back
about 10% of its shares outstanding each year - at today's stock price - using its
normal free cash flow. This would cause earnings to rise 11% a year (1/0.9 =
1.11). So, Q-Logic can grow earnings per share 11% a year without increasing
the capital invested in the business. And without the business actually growing
the topline. If the company's business neither grows nor shrinks, the stock price
stays the same, and all free cash flow is used to buyback stock - Q-Logic's
earnings per share will rise 11% a year.
That's significant considering Q-Logic is not priced like a growth stock and yet it
has a pretty foolproof method for achieving EPS growth of 11% a year. After all, if
the stock price goes up the return on buybacks goes down - but then,
shareholders get the consolation of a higher stock price which they can take
advantage of and sell their shares. It's a win-win if the business is stable.
But John Wiley can also increase EPS each year through buybacks.
So what's the difference?
The difference is one between theory and practice. Q-Logic has demonstrated an
extremely unusual willingness to buy back as much stock as possible - and pay
no dividends despite having the cash flow to pay large dividends - and to do it
every year. John Wiley has bought back stock at times. But they've also

increased share count and also left it pretty flat at times. Sometimes that's good.
If your stock is overpriced, it's good to not issue shares.
A few companies - very, very few - may in fact practice Henry Singleton like
attitudes toward buybacks. Most companies aren't even common sense using
enough to mention the fact that buybacks are a good idea below 15 times
earnings and a bad idea above 25 times earnings. If most companies simply
adhered to that strategy - buy below 15x earnings and stop buying above 25x
earnings - they'd have more success with their return on buybacks. Most can't do
even that.
Personally, I do not look for "smart" buybacks. I look for an admission of stupidity
on the part of the company. I look for a company that just always buys back stock
regardless of stock prices, future expectations, etc.
Why?
Because I already know the stock price when I buy into the company. I know if
the company is trading at 5 or 10 or 15 or 25 times free cash flow. I know what
return on my stock purchase I expect. The company is simply making the same
investment - albeit in its own stock - that I made in the company. All I care about
that I don't already know is whether or not they will buy back stock. And how
much will they buy back. I do, however, want to make sure they won't stop buying
back when the stock tanks. That is a major concern, because a lot of companies
do that.
This is the simplest part of the buyback question. If you as an investor have just
purchased the stock at today's price the question of whether you would prefer a
stock buyback or a dividend is a no brainer. You would prefer a stock buyback. A
company's investment in its own shares can never be less attractive than your
investment in that same company's shares. Never.
So if you are putting new money to work today in DirecTV (DTV) or Q-Logic or
John Wiley and you are correct in that purchase - then the company is correct in
devoting 100% of free cash flow to buybacks and 0% to dividends. There can be
no question about this. The question only arises in situations where you would no
longer be willing to put new money to work in the stock.
As an example, Berkshire Hathaway would be in favor of Coke using all of its
free cash flow to buyback stock in 1989 because Berkshire was buying Coke
then. Berkshire would not necessarily be in favor of Coke putting all its free cash
flow into buybacks today because Berkshire has the opportunity to put new
money to work in Coke at today's prices and instead prefers to buy Heinz, Wells

Fargo, IBM, etc. The 1980s care is clear, Berkshire had to prefer buybacks
because Berkshire was buying the stock itself. The 2013 situation is different.
Berkshire is no longer a buyer of Coca-Cola. Berkshire is a holder of Coca-Cola.
A lot of people overlook this simple rule. If you are a buyer of a stock, you ought
rationally to be in favor of that company paying no dividend and using all that
cash to buy back stock. There is no good argument against this. If you are a
holder of the stock, the story is different. It's complex and it may sometimes be
indeterminable whether you want a dividend or a buyback.
It depends a lot on your own return potential. Historically, I've been able to earn
15% a year in the stocks I bought. So, I am a bit biased in favor of dividends over
buybacks at stocks I hold but am no longer buying. I figure I can make 15% a
year on my own. So unless the company can make more than 12% to 13% (due
to taxes), it isn't clear that a buyback is better for me. But, again, that's based on
making 15% a year annualized since 1998-1999. The stock market performance
since 1998-1999 has not been as good as my personal performance. So, it's a
question of whether you believe your performance will or will not be better than
the market, whether your future performance will be like your past performance,
etc.
I doubt I can do 15% a year in the future. So, if I feel good a company I own can
earn 10% on a stock buyback - I'd tell them to go all out and skip the dividend.
Sometimes this is not practical. I own George Risk (RSKIA) and Ark
Restaurants (ARKR). When I bought them - and even now - I think their return
on buyback would be high and I'd be in favor of it. However, the stocks are illiquid
and their free cash flow relative to the dollar value of freely traded shares is not
high. As a result, I'm always in favor of RSKIA and ARKR buying back stock. But,
I understand it's very hard for them to do in practice unless there is a meaningful
holder who signals he wants out of the stock.
My approach to buybacks is pretty simple. One, I prefer them. Two, I look at the
share count history over the last 10 to 20 years as my guide to what the company
might do in the future - I want a pattern of predictable behavior. Generally, that
means a continuously shrinking share count that shrinks in bull markets and bear
markets, panics and recessions and booms and busts and so on. Three, if I'm a
buyer of the stock - then the company should be a buyer of its own stock. No
questions asked on that one. If the stock is good enough for me to buy it's clearly
good enough for the company to buy. Finally, I look for the return on buyback. I
tend to focus on the earning power the company is buying relative to the net cash
it is spending. If a company has cash on its balance sheet, the amount of net
cash consumed by a buyback will be less than it appears because I will end up

with a greater percentage ownership of the resulting balance sheet as well as the
income statement.
I want the return on buyback to always be at least 10%. As a rule, the average
company will only get returns on its buybacks of 10% or higher if it pays less than
15 times normal earnings. In special cases - fast growing companies, companies
where free cash flow vastly exceeds reported income, etc. - it is possible that
buybacks above 15 times earnings will return more than 10%. It almost never
makes sense for a company to buy back stock at over 25 times earnings. So, for
most companies, under 15 times earnings is the green zone for buybacks - 15 to
25 times earnings is the yellow zone, and over 25 times earnings is the red
zone.
You mentioned book value, etc. You can't value most companies on book value.
You need to look at owner earnings. Basically, what do you think the right
leverage level for DirecTV is? Feel free to use debt to free cash flow or
Debt/EBITDA or whatever you think is an appropriate metric. The question is - at
that leverage level - is FCF/Purchase Price acceptable? Is the extra free cash
flow (owner earnings) the company gets in the buyback worth at least the price
paid? Is it more than you can get in the stock market?
You probably don't want any buybacks where FCF/Market Cap< 6%. You
probably do want buybacks where FCF/Market Cap > 10%. So, as long as the
price paid is between 10 and 15 times owner earnings, it's a murky situation. If
the company is paying less than 10 times owner earnings it's either a good
purchase or the business is headed into oblivion. A flat or growing business is
worth at least 10 times earnings as long as it's a durable business. Once a
company is paying 15 times owner earnings or more for its own stock, the
question becomes growth. Some companies probably are worth 15 times
earnings while other probably are worth 25 times earnings. The perfect business
might be - might be - worth something like 33 times earnings. But it would have
to be a business with complete certainty for the future and that future would have
to involve growth equal to or greater than nominal GDP. I can't think of many
companies where GDP or greater growth is literally guaranteed. To the extent
they exist, they are probably worth close to 30 times earnings. Of, course Id
never pay 30 times earnings for a stock even if it were worth 30 times earnings.
For that reason, it's clear that buybacks are best at higher quality and more
durable companies. They are simply safer there. If Coca-Cola or Omnicom
chooses to always buy back stock, it'll tend not to destroy much value because
the stock will usually be trading at a reasonable level versus long-term prospects.
As a business's future becomes less certain - and its P/E higher - this is more
problematic. Sometimes even a company I like can trade at a silly price. It is hard

for me to argue in favor of Netflix, Under Armour, etc. buying back stock at some
of the prices where those stocks have traded regardless of what I think about the
businesses because the P/Es were simply too high at times.
For this reason, I think it's best to focus on companies that:
1. Have a wide and durable moat
2. Lower their share count every year
3. Are trading at a reasonable price right now
Those are the kinds of buybacks you want. And always prefer the past record to
buyback announcements, etc. I don't pay much attention to recent
announcements. I pay attention to past actions.
Ask Geoff a Question
About the author:
Geoff Gannon - formerly of Gannon On Investing - likes to answer questions
from you. If you have an investing question you want answered, please email
him at geoff@gannononinvesting.com.
In 1991, Seth A. Klarman published Margin of Safety: Risk-Averse Value
Investing Strategies for the Thoughtful Investor. This book outlined his thoughts
and approach to investing.
In this article, I would like to share some passages that I have compiled from
Chapter 8 (The Art of Business Valuation) of Margin of Safety. These passages
focus on Seth Klarmans three preferred methods of business valuation.
Before we jump full-force into these methods of business valuation, lets start
with an introductory quote from Mr. Klarman:
To be a value investor, you must buy at a discount from underlying value.
Analyzing each potential value investment opportunity therefore begins with an
assessment of business value. While a great many methods of business
valuation exist, there are only three that I find useful. (Margin of Safety, pg. 121)
The table below contains these three business valuation methods that Seth
Klarman finds useful. This table also contains definitions for these valuation
methods, some thoughts as to when it might be appropriate to use each
valuation method, and some notes related to each valuation method. Following

this table, I have also included some of Klarmans related thoughts on business
valuation and investing.
Valuation
Methods

1. Net
Present
Value
(NPV)
Analysis

Definition

When to Use it

Notes

"NPV is the discounted

value of all future cash
flows that a business is
expected to generate."
(Margin of Safety, pg.
121)

Going concern value.

"Net present value
would be most
applicable, for example,
in valuing a high-return
business with stable
cash flows such as a
consumer-products
company; its liquidation
value would be far too
low. Similarly, a business
with regulated rates of
return on assets such as
a utility might best be
valued using NPV
analysis." (Margin of
Safety, pg. 135)

"A frequently used but

flawed shortcut method of
valuing a going concern is
known as private-market
value. This is an investor's
assessment of the price that
a sophisticated
businessperson would be
willing to pay for a business.
Investors using this shortcut,
in effect, value businesses
using the multiples paid
when comparable
businesses were previously
bought and sold in their
entirety." (Margin of Safety,
pgs. 121-122)

"Liquidation analysis is
probably the most
appropriate method for
valuing an unprofitable
business whose stock
trades well below book
value." (Margin of
Safety, pg. 135)

"Breakup value, one variant

of liquidation analysis,
considers each of the
components of a business at
its highest valuation,
whether as part of a going
concern or not." (Margin of
Safety, pg. 122) "Most
announced corporate
liquidations are really
breakups; ongoing business
value is preserved whenever
it exceeds liquidation value."
(Margin of Safety, pg. 131)
"Liquidation value is
generally a worst-case
assessment." (Margin of
Safety, pg. 131)

A) Liquidation Value is
the "expected proceeds if
a company were to be
dismantled and the
assets sold off" (Margin
of Safety, pg. 122). B)
"The liquidation value of
a business is a
conservative assessment
of its worth in which only
tangible assets are
considered and
intangibles, such as
2.
going-concern value, are
Liquidation not." (Margin of Safety,
Value
pg. 131)
3. Stock
Market
Value

Stock Market Value "is an "A closed-end fund or "Less reliable than the other
estimate of the price at
other company that
two, this method is only
which a company, or its
owns only marketable
occasionally useful as a
subsidiaries considered
securities should be
yardstick of value." (Margin
separately, would trade in
valued by the stock
of Safety, pg. 122)
the stock market."
market method; no other
(Margin of Safety, pg.
makes sense." (Margin

122)

of Safety, pg. 135)

Related Thoughts on Business Valuation & Investing:

1. "Each of these methods of valuation has strengths and weaknesses. None of
them provides accurate values all the time. Unfortunately no better methods of
valuation exist. Investors have no choice but to consider the values generated by
each of them; when they appreciably diverge, investors should generally err on
the side of conservatism." (Margin of Safety, pg. 122)
2. "Often several valuation methods should be employed simultaneously. To
value a complex entity such as a conglomerate operating several distinct
businesses, for example, some portion of the assets might be best valued using
one method and the rest with another. Frequently investors will want to use
several methods to value a single business in order to obtain a range of values.
In this case investors should err on the side of conservatism, adopting lower
values over higher ones unless there is strong reason to do otherwise." (Margin
of Safety, pg. 135)
3. The Reflexive Relationship Between Market Price and Underlying Value: "A
complicating factor in securities analysis is the reflexive or reciprocal relationship
between security prices and the values of the underlying businesses. In The
Alchemy of Finance George Soros stated, 'Fundamental analysis seeks to
establish how underlying values are reflected in stock prices, whereas the theory
of reflexivity shows how stock prices can influence underlying values.' In other
words, Soros's theory of reflexivity makes the point that its stock price can at
times significantly influence the value of a business. Investors must not lose sight
of this possibility.... Reflexivity is a minor factor in the valuation of most securities
most of the time, but occasionally it becomes important. This phenomenon is a
wild card, a valuation factor not determined by business fundamentals but rather
by the financial markets themselves." (Margin of Safety, pgs. 136-137)
4. "Not only is business value imprecisely knowable, it also changes over time,
fluctuating with numerous macroeconomic, microeconomic, and market-related
factors. So while investors at any given time cannot determine business value
with precision, they must nevertheless almost continuously reassess their
estimates of value in order to incorporate all known factors that could influence
their appraisal." (Margin of Safety, pg. 118)
I hope this information on business valuation has been useful to you. I know it
has been to me.