I’m always surprised — call me naive — when a business journalist doesn’t “get” Finance 101. From Pumping Cash, Not Oil:
It’s Big Oil’s new formula for making money. Last year, Exxon pumped out $49 billion in operating cash flow on sales of $365 billion. It’s the world’s most profitable company, but Exxon is plowing a smaller percentage of its spare cash back into the business. Although capital expenditures have risen from $11 billion at the start of the decade to nearly $20 billion, that spending amounts to roughly 40% of cash flow, down from 50% in 2000. Meanwhile, overall production has barely budged since its megamerger in 1999.Instead, Exxon is bingeing on buybacks to help boost profits, which also benefit from higher commodity prices. Repurchases have been part of Exxon’s strategy for decades, but they’ve exploded in recent years. Exxon spent 60%, or $29 billion, of its cash flow on repurchases in 2006, more than any other company in the Standard & Poor’s 500-stock index and a tenfold increase since 2000. The company has retired 16% of shares in the past five years, adding an estimated 88 cents to earnings of $6.68 per share. With Exxon’s stock handily beating the market and peers with a 15% annual return over the past decade, others in the oil patch are catching on to the strategy. “They don’t need to grow production in order to generate shareholder returns,” says energy consultant Richard Gordon.
A profitable company can do one of two things with the money it earns: hold on to the money, or give it back to investors.
Theoretically, the company should hold on to the money only when it can reinvest it effectively. Young, growing companies in young, growing industries often can; old, mature companies in old, mature industries often can’t.
Management often likes having more money to play with — empire-building is fun — so it tends to find excuses not to give money back to investors. That’s what the oil execs did back in the 1970s; they found all kinds of bad projects to diversify into.
When a company does give money back though, it has a few options. Historically, it gave shareholders a cash dividend — pretty straightforward. Another option though is to buy back shares — which isn’t nearly as straightforward and still seems to confuse business journalists and unsophisticated investors.
When a firm gives out a dividend, all of its shareholders get the same amount of cash per share. When a firm buys back some of its shares though, some of its shareholders get a lot of cash in return for their shares, while the rest of the shareholders, the ones who didn’t sell their shares back to the company, now own a little bit more of the company.
Amazingly, it all works out.
Assume a firm has one million outstanding shares priced at $1, and the firm has $200k in cash it doesn’t need. This million-dollar company is actually an $800k-company, plus $200k in cash.
If it gives back all that cash to its investors, then each investor gets $0.20 per share — and the share price drops from $1 to $0.80.
If instead it buys back 200k shares, then some of its investors get $1 per share in return for their shares, and others hold on to their shares, which are now worth $1, even though the $200k in cash has been distributed — because their shares are now “bigger” than before. There are only 800k outstanding shares now, so each share is worth a bigger chunk of the company.
Not only does it all amazingly work out, but the investors who wanted cash got cash, and those who wanted to avoid a taxable event got to hold on to their shares as they grew in value.
Since “one share” no longer means what it used to mean, any per-share ratio from before the buy-back can’t sensibly be compared to one from after the buy-back, and business journalists should not pretend that the company has dramatically increased its earnings just because each share now has greater earnings.