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Bloopers & Blunders: ROE, Buybacks, and Value

"One final force pushing down shareholders' equity is the phenomenon of stock-buyback programs, a sort of corporate cannibalism with its own simple, self-reinforcing logic. It works like this: A company buys back stock; shareholders' equity declines; return on equity increases; future buybacks become even more alluring." Fortune, April 29, 1996.

If a company buys back its own stock what happens to the amount of equity outstanding, and the asset-to-equity ratio?

Obviously equity goes down and the asset-to-equity ratio goes up. To see this, use the simple identity

Assets = Debt + Equity.

Let’s plug in some numbers to see what happens. Suppose Debt=$20, Equity=$30 and the company buys back $10 worth of its own equity. Then,

Before stock buy-back: 20 + 30 = 50, implies Asset-to-Equity ratio = 50/30=5/3

After stock buy-back : 20 + 20 = 40; implies Asset-to-Equity ratio = 40/20=2

But 5/3 < 2.

Using the DuPont Identity,

ROE = (Net Income/Sales) x (Sales/Assets) x (Assets/Equity)

= profit margin x asset turnover x equity multiplier

If the asset-to-equity ratio increases, then ROE should go up.

Note that ROE is based on book values, not market values. This is why accounting ratios, in general, have a limited usefulness in measuring the true performance of a company.

Going back to the quotation, what is wrong with it is the last implication, namely that "future buybacks become even more alluring."

A manager can artificially increase ROE by either increasing the company’s debt or reducing its equity (through stock buy-back). This would make the company’s accounting numbers, as measured by ROE, look very good, although true value does not necessarily increase. Such action would increase value only if a higher debt level for the company is financially warranted. The authors of the quotation are implicitly associating an increase in ROE with an increase in the value of the company. Such a relationship is far from true.

It is transparent that if you push the ROE argument to its limit then the company should have 100% debt. I am sure your intuition says that such a policy would not increase value but would most likely drive the company to bankruptcy. Thus, future feedback does not necessarily become more alluring.

By Alex Tajirian