ShmoopTube

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principles of finance a la shmoop the math and rationale of buying back

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stock in context so we're continuing with our Blade Runner rom-com or

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thriller or maybe tragedy whatever it is when we last left off your drone company

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Blade Runner had made the corporate decision to heavily market its own [done company website]

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website and use that website as a meaningful part of its distribution

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strategy only problem the brick and mortar retailers full wreaked out when [people freak out in front of computer]

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they saw a gajillion ads for Blade Runner com all over the web and in

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reaction the brick and mortars simply D stocked your product or rather just [hand swipes drone product off self]

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stopped buying blade runner's whole sale by the train carload they still bought

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but at like half the volumes of the past they felt that your company in wanting

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to control its own distribution had been disloyal to the retailers who'd brung [retailers dancing at disco]

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them to the dance so Blade Runner now a public company missed its quarterly

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revenues and earnings guidance and projections and yes the stock plummeted

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from a hundred bucks a share to 30 out so what happens now well your London

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office calls you at 3:00 in the morning you hear something over the telly like [man picks up phone from bed]

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their bags resigning because their stock options are $70 under water our stock is [woman on phone near union jack flag]

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still falling and it can't get up all right well when you wake up from this

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terrible nightmare you take stock of your stock and it's bad from a hundred

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times trailing earnings with expectations of going from $1.00 to

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three in earnings in one year your stock has fallen some lady 8% now down to 12

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bucks a share over months it withered under an endless barrage of negative

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Wall Street sell-side analysts reports most of whom angrily feel bagged by you

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because they've been recommending that investors buy buy buy your stock even at

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$100 a share but now at $12 a share they've all turned negative and they

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think people should sell your stock at 12 even though three months ago they

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were buying it 100 yeah go figure welcome to Wall Street and you wonder

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how these people make so much money when very little has changed about your story [businessman daydreaming]

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other than a modest decline in growth projections how can they have loved it

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at a hundred and now hate it at 12 but with a rough now scratched lens you go

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over your assets and investing story in summary you have 30 million bucks in [businessman pulls out magnifying glass over clip board]

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cash it's like you spent a lot marketing the

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website and no debt and the street estimates of $3 a share in earnings are

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now just $1 for next year your stock simply continued to fall from what was

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perceived as 30 times earnings of 3 bucks and change yeah you remember

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ruefully that the street thought you would earn 3 bucks plus a sheriff and

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probably had six dollars a share in earnings the following year so when they

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paid 90 to 100 bucks a share for you while they were paying what they thought

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was 30 ish times forward earnings not a hundred times trailing but you missed

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your three bucks earnings number and your stock fell out of the hands of

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growth and momentum investors comfortable paying high multiples who

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continued to sell that stock down down down until value investors were willing

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to step up and pay 12 times earnings on the vastly reduced $1 a share in [stock changing hands]

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earnings for you yeah that's what happens growth investors puke out the

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stock when you miss until value buyers step up and stop the bleeding so finally [people watching movie in theatre]

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after a two-month long scene from the movie saw your stock stopped falling at

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12 bucks with new street consensus of $1 a share in earnings for next year and

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you think that dollar a share in earnings it's quote crazy cheap crazy

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conservative unquote but whatever you've lost street cred now because you really

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did thank you during three bucks at one point at least as of a year ago and now

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you won't and there's nothing you can do about it at least not now or is there

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well your cost of equity was super cheap at a hundred bucks a share like when

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your stock was trading it up hundred times earning that is you carried a huge

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market capitalization so buying things with your stock was easy you are paying

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with it via what almost felt like monopoly money your cost of equity at 12 [monopoly money on table]

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bucks a share now however is super expensive on the dollar of earnings a

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back-of-the-envelope cost was 1% when your stock was a hundred times that

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dollar in their earnings number at 12 bucks while that same dollar is 8% to

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raise a hundred million dollars in cash back then you only had to sell a million

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shares today you have to sell eight and a half million vastly more dilution if

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you ever needed that hundred million bucks in cash so your options change

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dramatically here selling equity is a non-starter if you need to raise cash

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do you do you need to raise cash do you need more than the 30 million bucks that

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you have now well your business is actually doing just fine by any normal [drones in factory production line]

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standards you're growing revenues thirty five percent a year now and without the

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retailer is pushing you thank you very much brick-and-mortar just not 200

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percent of your growth like you were in the beginning and 35 percent feels

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pretty sustainable for a while in fact after this hiccup with the brick and

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mortar retailer guys and the migration to web-only sales well you think you can [people at computer looking happy with drone website]

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do better than 35 percent of your revenue growth maybe a lot better

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you just didn't calculate the very fast timing of the retailers turning on you [hand pressing calculator buttons]

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and removing your drones from their prime shelf space they move so slowly [hand swipes drone product off shelf]

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and everything else well it shocked you that they move so quickly in this [tortoise runs off screen]

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instance so one more option remains you can do a whole lot of nothing let the

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company grow at its natural rate let the stock find its right price and

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yadda-yadda keep going but there is competition they all want shelf space

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they all want to kill you they are all handily taking advantage of your missed

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quarter openly telling everyone they can you're at risk of bankruptcy yeah you

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may go fully away and sell at fire sale prices to the hated / feared great and

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powerful goog well you need to fight this battle with your superior product [businessman with boxing gloves]

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your extra long life batteries that are powered by viagra and a game changer you

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need to fight the battle with retailing your own product ie the Battle of shelf [two businessmen fight with boxing gloves]

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space or web space so how do you do all this well you build it like you would

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just build the product yourself or you buy it you find competitors to buy your

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competitive products that are useful to you and you just buy them and at that

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same time you have a ton of very angry shareholders screaming at you they paid [angry people crowd screen]

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18 a share at the IPO they were loyal they stuck with you and didn't sell it a

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hundred bucks and now instead of making them rich you've lost them a third of

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their investment during a time when the rest of the stock market's gone up a

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bunch so they're vastly behind their peers now in the investing world is

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brutally competitive and because they're screaming in your ear you must listen

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because they're all on the edge of getting fired themselves and they want

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you to buy back your own stock wait a drum beat goes off in your head you went

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public not all that long ago selling shares to the public but wait now they

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want you to buy those shares back hmm so logically or structurally

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buying back stock what does that mean well you have thirty million dollars in

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cash on the books and no debt you'll have something like 25 million dollars

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in Nevada this year or cash flow and the banks are willing to loan you up to a

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seventy five million dollars in cash at five percent interest well you need five

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million dollars in working capital at the absolute minimum you know just to

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keep things flowing along as you're building more drones but you have a

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notional cash warchest of seventy five million bucks there and then debt money

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plus 30 million of cash on the books you had - the five million a working capital

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you need for inventory and plus whatever cash you'll generate in the next year

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right because you're actually generating cash like a real business well you have

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twenty million shares outstanding your stocks trading at twelve bucks so the

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market at this moment is valuing your company for just 240 million dollars

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that's it 240 the equity capitalization subtracts

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cash from the market cap hoping to get a truer picture of what the markets paying

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for the future earnings power of your company and the market is telling you

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that the equity value of your company ie the sum total of its projected future

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earnings or cash flows discounted back to present value is 240 minus the 30

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million their of cash you have today or just 210 million dollars you think this

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is crazy actually crazy cheap knowing what you know about the longer-term [people leaving businessman alone]

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prospects of your business like you're thinking you could earn that much money

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in a year in a few years you know that if you just ran the company for profits

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and not grow if it didn't worry about decades long long term greed well you [money flying across screen]

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could generate maybe half a billion dollars of cash in the next decade in [man dreaming about money while in bed]

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your sleep so to you it feels like the market is massively bearish on you [bear chases businessman in field]

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overly so over punishing you for missing that one quarter you trade it only about

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eight times EBIT Don about ten times free cash flow with huge growth

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expectations ahead and you think to yourself hey I didn't make up the street

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estimate the stockbrokers analysts did they came up with that three bucks a

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share thing in earnings and then they whispered about the six bucks it wasn't

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me but you admit to yourself in your quiet

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moments that for a few fleeting minutes it felt good to be famous and loved and [man walks down red carpet]

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popular at Wall Street functions and you didn't exactly unzip your pants at

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luncheons and urinate on their $3 your estimates either like you could

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have come out publicly and said there were morons but you didn't but whatever

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man plans God laughs there's nothing you can do about all that now you're the [laughing face of god in sky]

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quarterback you get over credited and over blamed so as always needing comfort

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food for the Soul you do some math for 12 million bucks you can buy back a

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million shares or 5% of the company you can easily swing the 12 million it's not

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like you need all that cash to grow your business you have no debt to service and

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plenty of cash to do things the way you want to do them so after a bunch of

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preparatory models based on a how your business runs and B how the stock price

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does you get your board to implement a share repurchase program and you file an [man presenting in meeting]

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8k notice to everyone that you are now buying back shares under the guidelines

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of a 10 B 5 1 plan and you're laying out the pricing and volumes at which you're

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gonna buy back stock well that publicly available filing lays

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out the maximum price and volume of shares that you'll buy in a given week

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day month quarter like you want to buy more than 5% of the total volume in a

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given day or week or whenever you won't buy when the moon is full you won't pay

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more than 15 bucks a share no matter what blah blah blah that's all in the 10

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B 5 1 all of this knowledge in the trading parameters you're setting has to

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be made broadly known and available because well too many shady companies in

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the early 20th century did shady things so a huge deal is made about loud [man takes money in back alley]

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ubiquitous public notice for things like this anyway the filings are made your [man tied up across railroad]

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bankers then set in place the buyback and quickly you buy back a million

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shares stopping the volatility of the stock and shoring up a liquidity in this

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sense liquidity referring to the high volumes of stock that have been trading

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each day after your misses well your average had been 300,000 shares a day [liquidity coming in and out with the tide]

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then when you missed your quarter volume spike to well over a million shares a

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day for a while until all the growth and Mojo investors had puked you out only to [investor pukes]

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be gobbled down by cat vomit licking value investors but now you have only 19 [cat eats vomit]

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million shares out well what does that mean well one cool thing is that to earn

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$1 a share now you only need to earn 19 million dollars not 20 million that last

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million of pressure being gone well it feels kind of good maybe you should buy

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back some more shares but as it has become well-known that the company is

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buying back its own stock while the active sellers at 12 bucks are

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generally going away now they want 13 14 15 dollars a share so your little share

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repurchase adventure comes to an end pretty quickly at least for now

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as you hold your breath hoping that the 35% growth projections actually hold the

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share repurchase was small it did however take your cash balance down from

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30 million bucks to 18 million and given that you may have to invest in more

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marketing of your website or pay retailers for shelf stocking spaces you [woman scrolling on computer then handing out money]

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realize you may need the debt money so you keep that offer from the banks of a

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5% loan of up to 75 million bucks is a kind of hurdle rate in your head should

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you ever decide you really do need a lot more cash the share repo itself was more

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emotionally significant to the Wall Street crowd than anything else it said

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that you believed in your company that you think they're idiots for selling it

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at 12 bucks and they all know that you have a chip on your shoulder now about [poker chip rolls down man's shoulder]

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shoving it in their face that they sold you down so aggressively all right

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you're a lion you have zebras to go kill

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