Below are some personal notes on how high ROIC’s can raise a stock’s per share intrinsic value, using Apple as an example:
- Apple has authorized $100B plus in share repurchases going forward, a result of robust returns on capital — the company is generating more cash than it needs for the business. Repurchases cause share count to go down, causing EPS to grow and market cap to decline, despite flattening/declining operating earnings.
- High returns on capital — and capital returns via prudent buybacks — should allow Apple to continue growing EPS and reducing market cap at a rate that arguably makes the company undervalued despite slower growth in operating earnings.
- Apple shouldn’t be making share repurchases if the shares are overvalued — repurchases in this situation are a waste of balance sheet cash. In this situation excess capital should instead be paid out as dividends, leaving shareholders free to invest these monies in other investment opportunities.
- It’s interesting how a company can grow EPS through share buybacks without growing bottom line earnings. These buybacks should be at fair value or less to avoid wasting balance sheet cash. Buybacks reduce share count, which reduces market cap (the total market price of the company) and increases per share cash flows, both of which make a company more attractive/undervalued from a present value, DCF perspective. This is one of the big benefits of high returns on capital: if a portion of earnings isn’t operationally needed and can’t be invested in incremental capital at attractive return rates, then these earnings can still be used to reduce share count, which reduces total market price and grows per share cash flows, which then leads to a more attractive price to present value ratio (applying DCF analysis).
- When a company pays more than fair value to repurchase shares, it’s like the company is indirectly making shareholders pay too much for shares relative to earnings — i.e., it’s like forcing shareholders to buy a stock with a low earnings yield, a long payback period, and an unattractive price to present value ratio.
- An interesting question is whether buybacks at slightly more than fair value could still benefit existing shareholders, and ultimately lead to an attractive earnings yield on the repurchased shares (after repurchases are complete), by increasing the value of each share since each share is now entitled to a greater percentage of earnings.
- It’s easy to imagine a cash cow type company with high returns on capital liberally repurchasing shares and hypothetically offsetting any unfavorable purchase price (with a low earnings yield on repurchases) with the higher earnings now attributable to each share. The bottom line is that as EPS goes up each share becomes more valuable on a pure DCF basis (ignoring any resulting new debt and/or irresponsible depletion of balance sheet cash by management).
The author is not an investment advisor or CFA and readers should consult an investment advisor before buying or selling any publicly traded stock. The views expressed in this article are the author's personal opinions and should not be construed as investment advice. The author owns stock shares of Apple.