Gordon equation-stock buybacks

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Andyman
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Gordon equation-stock buybacks

Post by Andyman »

I came across a spreadsheet that calculates the equity risk premium and it includes stock buybacks in determining the stock market yield. I would be interested to hear how Bernstein and others think buybacks factor into the expected return on stocks under the Gordon equation. Should we consider buybacks dividend equivalents for this purpose?
larryswedroe
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Re: Gordon equation-stock buybacks

Post by larryswedroe »

Here's piece I wrote on the literature on "true yield"

http://www.etf.com/sections/index-inves ... turns.html

Larry
steve_14
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Re: Gordon equation-stock buybacks

Post by steve_14 »

I trust you're netting out dilutions there.
TJSI
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Re: Gordon equation-stock buybacks

Post by TJSI »

Andyman,

I don't think buybacks are easily incorporated into the Gordon Equation. They are not dividends although they might effect future dividend flows--positively or negatively. The Gordon equation is based upon discounted cash flows and buybacks most directly effect capital gains.

I don't think there is any really good analysis on the effect of buybacks on long term returns. There is lots written about them and they are massive and important. But I believe the story is yet to be written on their long term effect.

TJSI
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camontgo
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Re: Gordon equation-stock buybacks

Post by camontgo »

Andyman wrote:I would be interested to hear how Bernstein and others think buybacks factor into the expected return on stocks under the Gordon equation.
Bernstein wrote a paper with Robert Arnott in 2003 that had a very good discussion on the net effect of buybacks and dilution.

http://portfolioconstruction.com.au/obj ... growth.pdf

Most of the analysis I've seen show that the net effect over long periods is a fairly small (though perhaps not negligible). For example, see the paper "A Supply Model of the Equity Risk Premium" which is available in the collection of papers here:

http://www.cfainstitute.org/learning/pr ... emium.aspx

The authors apply Bernstein and Arnott's method over a more recent time period (thru 2009 I think). It shows the net of buyback and dilution adding about 0.2% to the annual dividend yield.

This paper also has a good footnote explaining why net buybacks can be viewed as either a capital gain gain component or a income component:
Share buybacks may be viewed as either a component of income return or a component of capital gain. An owner of a single share who holds on to the share through the share buyback program experiences the buyback as a component of capital gain because the same earnings are divided among fewer shares, which causes EPS to rise although earnings (not per share) have not changed. ...... An index fund investor, however, experiences the share buyback as cash income because the index fund manager—who tenders some of the shares to the issuer to keep the stock’s (now decreased) weight in the fund proportionate to its weight in the index—receives cash, which is then distributed to, or held by, fund shareholders like any other cash (tax considerations aside).
Also, another comment on the dilution which offsets buybacks. This is a favorite quote of mine from Paul Krugman article on the the Dow 36,000 book....which used a Gordon Equation calculation.
Third, the deepest issue: today's stocks are not a claim on the earnings of the U.S. corporate sector into the indefinite future. They are a claim on the earnings of today's corporations into the indefinite future. That's a big difference, if you look far enough ahead: unless something terrible happens, U.S. companies will be earning a lot of money 70 years from now; but much of that money will be earned by companies that do not now exist, or at any rate are not in the Dow or even in the S&P 500.
Link here: http://web.mit.edu/krugman/www/dow36K.html
"Essentially, all models are wrong, but some are useful." - George E. P Box
TJSI
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Re: Gordon equation-stock buybacks

Post by TJSI »

camontgo,

Thanks for the interesting links! I found the article "A Supply Model of the Equity Premium" most interesting as they attempt to provide an analytic model of the effect of buybacks.

However, I believe their analysis and model is flawed. First they conflate price changes with cash dividends. Although a price change may provide some enjoyment, it is not cash and can't be deposited in your checking account.

Second they justify a price change by assuming the P/E stays constant and that earnings per share increases due to buyback deserve the same P/E as operating earnings. This is faulty. Earnings per share increases due to financial engineering (buybacks) probably deserve a valuation of 1.

Buybacks are often stayed as benefiting "stockholders". However, this statement is not accurate. It should really be stated as "stock buybacks benefit some stockholders". There are two classes of stockholders created by buybacks --selling stockholders and non-selling stockholders. Who benefits and who loses depends on whether the stock is purchased above or below its intrinsic value. Dividends benefit all stockholders while buybacks only benefit a fraction of stockholders.

In any event it was an interesting and thought provoking article.

TJSI
Valuethinker
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Re: Gordon equation-stock buybacks

Post by Valuethinker »

You should be aware that Modigliani and Miller amongst others have pretty much answered your objections.
TJSI wrote:camontgo,

Thanks for the interesting links! I found the article "A Supply Model of the Equity Premium" most interesting as they attempt to provide an analytic model of the effect of buybacks.

However, I believe their analysis and model is flawed. First they conflate price changes with cash dividends. Although a price change may provide some enjoyment, it is not cash and can't be deposited in your checking account.
You can sell a portion of your holding and thus reap the 'dividend' from owning it.

Second they justify a price change by assuming the P/E stays constant and that earnings per share increases due to buyback deserve the same P/E as operating earnings. This is faulty. Earnings per share increases due to financial engineering (buybacks) probably deserve a valuation of 1.
That's a 'should' ie an opinion rather than something which is intrinsic to the model. The model would say there is no such should, and whether there is or not is debatable. There is if there are significant agency costs, I suspect (I'd have to think about that).
Buybacks are often stayed as benefiting "stockholders". However, this statement is not accurate. It should really be stated as "stock buybacks benefit some stockholders". There are two classes of stockholders created by buybacks --selling stockholders and non-selling stockholders. Who benefits and who loses depends on whether the stock is purchased above or below its intrinsic value. Dividends benefit all stockholders while buybacks only benefit a fraction of stockholders.

In any event it was an interesting and thought provoking article.

TJSI
that's probably the most basic point in any academic finance textbook. Assuming no taxes (symmetric treatment of capital gains and dividends) or transactions costs (and no agency costs) then the shareholder is indifferent between stock buybacks and dividends.
TJSI
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Re: Gordon equation-stock buybacks

Post by TJSI »

After a little thought, I will modify the statement about the valuation assigned to manufactured ( non-operating) earnings per share. The P/E should be near 1. If the stocks purchased are undervalued, than the P/E assigned to those earnings would be greater than 1. So if a stock is purchased at 70% of its fair value, then the P/E assigned to the manufactured earnings per share should probably be 1.3. Similarly, of the buybacks result in purchasing stocks that are overvalued, then the P/E should be less than 1. If 30% overvalued, then the P/E for the manufactured earnings per share would be .7.

In no case would the P/E of the manufactured EPS be the same as the P/E of the operating EPS.
Jack
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Re: Gordon equation-stock buybacks

Post by Jack »

Valuethinker wrote:You should be aware that Modigliani and Miller amongst others have pretty much answered your objections.
Modigliani and Miller is a toy model with some important simplifying assumptions suitable for Econ 101. It assumes that there is only one stock in the universe, that stock buybacks occur at fair market price, and that you only have two choices -- dividend or buyback of one stock. None of these simple assumption hold in the the real world, which is typical of many Econ 101 concepts.

A stock buyback is a risky market-timing, stock-picking exercise. Rather than allow the shareholder to re-invest dividends efficiently in the diversified total stock market, the CEO makes a decision for you to take all of your dividends and invest them all in one stock and at a price of his timing. This is market-timing and stock-picking at its worst.
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Ketawa
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Re: Gordon equation-stock buybacks

Post by Ketawa »

Jack wrote:A stock buyback is a risky market-timing, stock-picking exercise. Rather than allow the shareholder to re-invest dividends efficiently in the diversified total stock market, the CEO makes a decision for you to take all of your dividends and invest them all in one stock and at a price of his timing. This is market-timing and stock-picking at its worst.
Except an index fund is forced to sell shares of the company in keeping with its free float capitalization, so individual investors aren't actually market timing the stock.
Valuethinker
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Re: Gordon equation-stock buybacks

Post by Valuethinker »

Jack wrote:
Valuethinker wrote:You should be aware that Modigliani and Miller amongst others have pretty much answered your objections.
Modigliani and Miller is a toy model with some important simplifying assumptions suitable for Econ 101. It assumes that there is only one stock in the universe, that stock buybacks occur at fair market price, and that you only have two choices -- dividend or buyback of one stock. None of these simple assumption hold in the the real world, which is typical of many Econ 101 concepts.

A stock buyback is a risky market-timing, stock-picking exercise. Rather than allow the shareholder to re-invest dividends efficiently in the diversified total stock market, the CEO makes a decision for you to take all of your dividends and invest them all in one stock and at a price of his timing. This is market-timing and stock-picking at its worst.
The Modigliani-Milller response to that is if the shareholder sells stock in proportion to the buyback, and reinvests the money received in a diversified portfolio, that's the same as having received a dividend.

We've had this discussion before and as far as I can work out you just can't get your head around that step. I *think* because you keep jumping ahead to a world of agency problems/ imperfect information. But then if you include a lower rate of taxes for capital gains tax rate being lower than dividend tax rates, that again tilts it towards the investor preferring stock buybacks to capital gains. i.e. it does rather depend which market imperfections one wants to consider.

In the absence of information costs/ asymmetric information, M & M's logic is correct (if we assume away dealing spreads, which are not large for liquid stocks).
Jack
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Re: Gordon equation-stock buybacks

Post by Jack »

Valuethinker wrote:The Modigliani-Milller response to that is if the shareholder sells stock in proportion to the buyback, and reinvests the money received in a diversified portfolio, that's the same as having received a dividend.
That is not what M&M say. You keep misrepresenting M&M's work. In fact, appropriate to the title of this post, that is precisely Gordon's criticism of of M&M, that dividends provide the opportunity for alternative, less risky reinvestment strategies.

The assumption of M&M is that your only option for reinvestment is to reinvest in the same stock (or its equivalent). They most certainly did not say that reinvesting in a diversified portfolio was equivalent. Why do you insist on making things up? They never said that.

How could you possible conclude that investing in one single stock is equivalent to investing in a diversified portfolio?
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