Graham Turner, the founder and current CEO of Flight Center, in...

Graham Turner, the founder and current CEO of Flight Center, in his 2016 presentation at the AGM included a slide which stated: "Capital Management: Buy-back  attractive option if share price is undervalued". He gave no other reason for a buy back because there isn't one. Shares should only be purchased if the share price is lower than the intrinsic value of the company. Such a strategy is value-accretive for shareholders.

Adacel states a different  purpose for its share buyback: "to increase earnings per share and return on equity" and "to return excess capital to shareholders in an efficient matter" The trouble is these points still only make sense if the shares are undervalued.

By way of example, consider a company with 2 shares earning $5 a year in its business activities. The company has $100 in surplus cash, built up from initial capital and retained earnings.   I will assign it an intrinsic value of $75 per share. I have calculated this by using a PE of 10 to multiply the $5 earnings to get $50 then added the surplus cash in to give an intrinsic value of $150 for the entire company, so each share is worth $75.

In this example the equity of the business (cash) is $100, so the earnings of $5 give a return on equity (ROE) of 5%. Earnings per share are of course $2.50 ($5 earnings /2 shares)

If the company decides to conduct a share buy-back of 1 share, how will its objectives be met if it:

1. pays more than the intrinsic value (say $90)?
2. pays the intrinsic value (say $75)?
3. pays less than the intrinsic value (say $60)?


Example 1. Pays more than intrinsic value:

Amount spent on buy-back: $90
Shares remaining after buyback: 1
Equity after buyback: $10
Earnings after buyback: $5
Earnings per share after buyback: $5
ROE after buyback: $5/$10 = 50%
Intrinsic value after buyback (PE10 x $5 )+ $10 =$60

Example 2. Pays equal to intrinsic value:

Amount spent on buy-back: $75
Shares remaining after buyback: 1
Equity after buyback: $25
Earnings after buyback: $5
Earnings per share after buyback: $5
ROE after buyback: $5/$25 = 20%
Intrinsic value after buyback (PE10 x $5)+ $25  =$75

Example 3. Pays less than intrinsic value:

Amount spent on buy-back: $60
Shares remaining after buyback: 1
Equity after buyback: $40
Earnings after buyback: $5
Earnings per share after buyback: $5
ROE after buyback: $5/$40= 12.5%
Intrinsic value after buyback (PE10 x $5 )+$10 =$90

So we can see that by simply reducing the amount of cash in the company that ROE increases. In fact the more cash the company spends (higher price it pays for the buyback) the better the resulting return on equity. Also, in all three examples the earnings per share has doubled as the number of shares has halved. So the stated aim of increasing earnings and ROE can be achieved at any price.

What is starkly obvious however is that the intrinsic value of the remaining share is only increased if the share buy-back is undertaken at a price below intrinsic value. The less paid for shares in the buyback the greater the value of the remaining shares (or share in this example). The buyback has only been value-accretive when a price below intrinsic value has been paid.

In conducting share buybacks, which Adacel has consistently done over the past 10 years they have been meeting their stated objectives, but it would be worth ignoring any buyback activity as a window into management's view on the company's intrinsic value. We have to come to our own conclusion on value and that is something I have struggled to do.