A SeekingAlpha reader, Bob, sent me a note regarding a video I had done some time ago called Three Ways Buybacks Hurt Investors. This video talks about how we estimate the amount of “backdoor” compensation a company is paying out to its executives and employees by issuing them stock options and Restricted Stock Units (RSUs).
The point I make in the video is that most companies trumpet their enormous buyback program announcements while all the same time, they are giving shares away to their employees on the QT.
If a company buys back 100 shares, but issues 30, for instance, the company has taken 10 steps forward and three steps back in terms of the dilution of the interests of the existing shareholders. My argument is that this stock issuance has a real cash cost that should be estimated and deducted from what we call Free Cash Flow to Owners (FCFO).
Because FCFO is the quantity we use to estimate the value of a firm, the cost associated with these “Antidilutionary Stock Buybacks” reduces our estimate of the company’s intrinsic value.
Bob asked me to walk through how I would estimate this cash cost in the case of pharmacy and Pharmacy Benefits Manager CVS (CVS).
The process is easy, but sometimes it takes a little practice to find the numbers in a set of financial statements. The steps to take are as follows:
- Find the “Consolidated Statement of Shareholders’ Equity” and “Consolidated Statement of Cash Flows” in the company’s annual statement (Form 10-K). The statement of shareholders’ equity is not available in quarterly statements.
- Figure out how many shares the company issued using the statement of shareholders’ equity.
- Figure out how much money the company received when those shares were issued.
- Figure out the average price of the shares over the year covered by the annual statements.
- Estimate the cash cost by multiplying the average price of the shares found in step 4) with the number of shares issued found in step 2).
- The difference between the assumed cash outflow in step 5) and the reported cash inflow from step 3) yields our estimate of cash spent on antidilutionary stock buybacks.
Let’s look at CVS’s financial statements and make this calculation for 2016. (For those of you who need a refresher on how financial statements are set up and arranged, and what information each contains, please see our complementary mini-course entitled The Language of Business).
STEP 1
I downloaded CVS’s most recent 10-K from its Investor Relations site and searched the form for “consolidated statements.” After that, it was easy to find the two statements I needed. I turned first to the Consolidated Statements of Shareholders’ Equity.
STEP 2
CVS makes this step easy (some firms, especially “old economy” firms, make step two a pain, so I was glad that Bob chose an easy company).
Look at the columns labeled “Shares;” we want to find the number of shares issued in Step 2, not the dollar values. Notice the row reading “Stock options exercised and issuance of stock awards.” For 2016, the company issued 6 million shares.
In addition, if we look below that, in the sub-section labeled “Treasury stock” we see one more line reading “Employee stock purchase plan issuances” associated with the value 1 million. We simply add these two lines together and end up with 7 million shares issued for our answer to Step 2.
(Note that the company purchased 47 million shares of treasury shares, so in essence, CVS took 47 steps forward and 7 steps back from the perspective of the shareholders.)
STEP 3
To find out how much money the company received for these shares, we turn to the Statements of Cash Flows.
Information about cash received for stock or debt issuance or paid for stock buybacks and debt retirement is found in the section entitled “Cash flows from financing activities.”
In that section, look for something related to stock issuance, stock options, or stock-based compensation.
Looking through, you should see three lines that have the word “stock” in them: Proceeds from exercise of stock options, Excess tax benefits from stock-based compensation, and Repurchase of common stock.
Many people focus on the “Repurchase of common stock” line, but in fact, we want to look at the other two lines (look back at the description of the steps to confirm this).
Doing so, we can see that the company received $224 million when stock options were issued and received a $72 million tax shield because it paid employees in stock options. In total, the company generated cash inflows of ($224 + $72 =) $296 million during 2016. That’s our answer for Step 3.
STEP 4
To figure out the average price of CVS shares during 2016, I turned to YCharts.
You can see above that the average share price that year was $93.05. Bob wrote that he found the same figure by looking on the NASDAQ website. This is our answer for Step 4.
STEP 5
Now we have all the requisite information. In Step 5, we just need to multiply the number of shares issued (7 million) by the average share price ($93.05). This gives us a figure of $651.35 million.
We assume that among the 47 million shares of stock the company bought back during 2016 were 7 million shares issued to employees. The $651.35 million figure is our estimate of the cash outlay the company had to make to repurchase the shares it issued to employees.
STEP 6
In the last step, we just net out the presumed $651.35 million outflow with the $296.00 million inflow from share sales that we found in Step 3. Doing so yields a net cash outflow of ($296.00 – $651.35 =) $355.35 million.
To put it another way, the board and management of CVS decided to take $355.35 million that would have otherwise flowed through to shareholders and pass that money through to sweeten employees’ compensation packages.
Is this level of compensation unusual? Most certainly not! Many firms renowned for their stinginess (ahem, Wal-Mart…) issue massive amounts of stock to employees every year that total in the hundreds of millions of dollars.
Whether this money is misspent is another issue. As long as this investment in its employees is paying off in the long run by employees who are more energized, creative, and eager to see the company succeed, this investment should be looked at in the same way investment in a new piece of equipment or computer system should be.
To determine that, we need to look at the company’s “investment efficacy,” but that is the topic for another article!