Save the Buyback,Save Jobs

In response to a recent New York Times op‐ed by Senators Schumer and Sanders deploring the effects of stock buybacks on workers and the economy, the authors explain the role of buybacks in increasing corporate productivity and in recycling “excess capital” from mature companies with limited growth and employment opportunities to the next generation of Apples and Amazons. Some companies, as Schumer and Sanders charge, are guilty of repurchasing shares in the name of “shareholder value maximization” instead of pursuing job‐creating investments. But as the authors argue, well‐run companies increase shareholder value not by boosting EPS through buybacks, but mainly by earning competitive returns on capital and investing in their long‐run “earnings power.” And by paying out capital they have no productive uses for, such companies give their own shareholders the opportunity to reinvest in other companies with promising prospects for growth and jobs. But the authors go on to note the tendency of companies to buy back shares not when their stock prices are low, but instead when the companies are flush with cash and nearer the top than the bottom of the business cycle. The result of this tendency, as research by Fortuna Advisors (the authors' firm) shows, is that fully three quarters of companies doing large buybacks during the period 2013‐2017 failed to produce an adequate “Buyback ROI,” a metric developed by Fortuna that indicates management's effectiveness in “timing” its stock repurchases. Given the usefulness of buybacks in recycling capital, the authors conclude that the most reliable solution to the corporate short termism and underinvestment problem is for companies to adopt better financial performance measures—including Buyback ROI—to guide their capital allocation. And when management determines that it has significantly more capital than value‐adding investments, but wants to avoid committing to unsustainable dividend increases, it should consider buybacks—but only if management is convinced that its stock price has not outpaced performance.     

Beyond EVA

A former partner of Stern Stewart begins by noting that the recent acquisition of EVA Dimensions by the well‐known proxy advisory firm Institutional Shareholder Services (ISS) may be signaling a resurgence of EVA as a widely followed corporate performance measure. In announcing the acquisition, ISS said that it's considering incorporating the measure into its recommendations and pay‐for‐performance model. While applauding this decision, the author also reflects on some of the shortcomings of EVA that ultimately prevented broader adoption of the measure after it was developed and popularized in the early 1990s. Chief among these obstacles to broader use is the measure's complexity, arising mainly from the array of adjustments to GAAP accounting. But even more important is EVA's potential for encouraging “short‐termism”—a potential the author attributes to EVA's front‐loading of the costs of owning assets, which causes EVA to be negative when assets are “new” and can discourage managers from investing in the business. These shortcomings led the author and his colleagues to design an improved economic profit‐based performance measure when founding Fortuna Advisors in 2009. The measure, which is called “residual cash earnings,” or RCE, is like EVA in charging managers for the use of capital; but unlike EVA, it adds back depreciation and so the capital charge is “flat” (since now based on gross, or undepreciated, assets). And according to the author's latest research, RCE does a better job than EVA of relating to changes in TSR in all of the 20 (non‐financial) industries studied during the period 1999 through 2018. The article closes by providing two other testaments to RCE's potential uses: (1) a demonstration that RCE does a far better job than EVA of explaining Amazon's remarkable share price appreciation over the last ten years; and (2) a brief case study of Varian Medical Systems that illustrates the benefits of designing and implementing a customized version of RCE as the centerpiece for business management. Perhaps the most visible change at Varian, after 18 months of using a measure the company calls “VVA” (for Varian Value Added), has been a sharp increase in the company's longer‐run investment (not to mention its share price) while holding management accountable for earning an adequate return on investors’ capital.     

What do accruals tell us about future cash flows?

Our model, which is adapted from Feltham and Ohlson (Contemp Account Res 11:689–731, 1995) and Ohlson (Contemp Account Res 11:661–687, 1995) and extends Dechow and Dichev (Account Rev 77:35–59, 2002), characterizes the information about future cash flows reflected in accruals. It reveals investors can extract from accruals information about next period’s economic factor and the transitory part of one component of next period’s cash flow. The extent to which each accrual provides this information depends on whether the accrual aligns future or past cash flows and current period economics and whether it relates to the current or prior period. Thus each type of accrual has a different coefficient in valuation and forecasting cash flows or earnings. Each coefficient combines an information weight reflecting the information that accrual type provides and a multiple reflecting how that information is used in valuation and cash flow and earnings forecasting. The empirical evidence supports our main insight, namely that partitioning accruals based on their role in cash-flow alignment increases their ability to forecast future cash flows and earnings and explain firm value.     

University of Texas Roundtable on Financing and Managing Energy Investments in a Low‐Price Environment

During the past 18 months, the U.S. oil industry has seen oil prices plunge from well over $100 a barrel to under $30. In a session that was part of a recent Private Equity Conference at the University of Texas in Austin, the CEO of a small independent producer and a representative of a large global oil and gas company discussed the challenges of financing and operating energy companies in today's low‐price environment with the director of energy research at a brokerage firm, the senior partner responsible for the natural resource investments of a well‐known private equity firm, and the head of the oil and gas restructuring practice of a national law firm. The panelists appeared to reach a consensus on at least the following three arguments:

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