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Sunday Brunch: profits, buybacks and sustainability
Sustainability, Strategy & Finance (Copenhagen stock exchange, image by Wolfgang Claussen from Pixabay

Sunday Brunch: profits, buybacks and sustainability

High levels of share buybacks are often quoted as evidence that companies can afford sustainability investments. But the link is poor and better measures, such as profit margins and ROIC are available.


 β€œThe surest way for a company to use its cash intelligently is through disciplined share repurchases” Warren Buffett

I frequently read about how some sectors, including European banks, have been massive users of share buybacks. This is a financial transaction where a company buys its own shares and then (normally) cancels them. This increases profit measures such as earnings per share, but just mathematically as profits are often unchanged but they are now spread over fewer shares.

There are pro's and con's to share buybacks. But before we can consider if buybacks are right for a company, we need to tackle the more emotional issue of how they are (wrongly in my view) perceived by some politicians and many journalists.

To many observers high levels of share buybacks imply that companies are generating excessive profits, and that they are not using them wisely. This seems to be a fairly widespread view - with politicians in many countries blaming buybacks for low levels of investment and R&D. And among the popular press, high levels of buybacks are seen as a sign that companies are making 'super profits'. The implication is that it's exploitative or an abuse of monopoly power, and that it needs to be regulated.

Buybacks and sustainability arguments

Which is where the link to sustainability comes in. It's not uncommon to read that sustainability actions are something that a company should commit to, and that they can afford it. And sometimes the evidence used for affordability relates to the level of buybacks. This implies a link between a company's level of buybacks and its profitability - a link that doesn't really exist.

As an aside, I am not sure profitability is the right test (for instance, companies with low profits should also be thinking about how best to invest in their staff). But more fundamentally this analysis mixes up profit generation, with what companies do with those profits (buybacks etc).

As sustainability professionals, we need a 'better' measure of affordability. In my view the best test is 'does this sustainability measure provide a strong long term benefit for the company". But if we want a better affordability metric as well, I favour sector relative profitability margins, combined with return on invested capital (ROIC). But before we talk about why ROIC is such a good and useful metric, we need to clear up the difference between profitability and money spent on buybacks.


Let's start from the basics.

Profits are (loosely) a measure of how much money a company generates from its operations. By contrast spending on share buybacks and dividends (and also capital investment) is the choice they make about how to spend these profits.

The most commonly used measure of profits is earnings per share or EPS. It's actually a poor measure if we want to understand how profitable a company is but it's useful in this case to illustrate a point. Earnings used for this metric (often called net profit) are profits after all of a company's operating costs, interest paid and tax. These earnings relate to a specific year.

One sustainability related argument is that companies with high levels of profitability are better placed to undertake sustainability related actions and investments. It offsets the frequent counter argument, which is we would love to do X, but we just cannot afford to, our industry is just way too competitive.

That's profits. Now switching to buybacks. Once companies know how much profit they make, they can broadly do three (constructive) things with their available cash. They can invest in tangible assets such as new factories etc or intangible assets such as human capital, brands and R&D. Or they can return surplus cash to shareholders via 1. dividends and/or 2. share buybacks. If a company has good investment opportunities they should be investing.

If not they should be returning the surplus cash to shareholders. How they do this (the split between dividends and buybacks) has lots of moving parts. But in very simple terms a company should select more buybacks if the current share price is below their estimate of the company's 'intrinsic value' ie what they have calculated that it is worth. Putting this another way, they are buying back their own shares for less than they are worth.

But companies also have to consider how the market interprets their dividend vs buyback decision - higher levels of dividends can be interpreted as confidence in the future. Why ? Because most companies try not to cut the dividend, and so paying a higher dividend, and using buybacks less, can signal that the company expects future profitability to be strong.

Coming back to the point of this blog. While affordability might be one measure that sustainability professionals and investors consider when thinking about why a company should take a certain sustainability action - we should not use a high level of share buybacks as part of that argument. Buybacks tell us little about affordability.

I want to come back to better affordability metrics in a future blog. But for now I encourage you to read up about the return on invested capital metric and what it can tell us about the profitability of a company. And how sustainable it is. This paper from Michael Mauboussin and Dan Callahan at Counterpoint Global is one of my favourites.

ROIC and the Investment Process
We examine the link between changes in ROICs and shareholder returns and review elements of competitive strategy as well as persistence of ROIC by sector.

One last thought

I mentioned earlier in the blog that even companies with low profitability (=low affordability) should actively think about making sustainability linked investments. One of the more important ones is investing in your staff, or what sometimes gets called human capital.

For most companies employees are their most important source of competitive advantage. Your staff are who your customers deal with every day, they are the people who deliver your new strategy, and they are probably where much of your innovation comes from. It makes perfect sense to develop them and treat them well. In fact it might be the only way to shift from low to higher profitability. But this is different from some measures of diversity (part of the S in ESG).

Sunday Brunch: investible diversity
Diversity matters, but not the diversity you might think. It has become an accepted fact that there is a strong link between demographic diversity and financial returns. But it’s not actually supported by rigorous analysis.

Please read: important legal stuff.

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