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Apple Inc. (AAPL), DIRECTV (DTV): Earnings Yield and Evaluating Stock Buybacks Funded With Debt

Using borrowed money to buyback stock is all the rage nowadays, as companies make use of the low interest rates and insatiable demand in the bond markets to issue debt and then return the money to shareholders.

But how useful and how effective is this method? I am skeptical of any company that issues debt in order to buy back stock, as most companies tend to pay too much for their shares while buying back.

Apple Inc. (AAPL)The effectiveness of buybacks that are funded through debt can be worked out with a comparison between the company’s earnings yield and the after tax cost of its borrowing.

The earnings yield per share is the total of ttm earnings per share and its dividend by the company’s share price. This figure shows investors the percentage of each dollar invested in the stock that was earned by the company.

The earnings yield can also be used to determine whether or not the company is over, or undervalued when compared to the prevailing interest rate, or risk free rate such as the 10-year Treasury. If the earnings yield is below the risk free rate, then the stock is overvalued.

So, here are three different companies buying back stock with debt and the effectiveness of their buyback programs measured by the earnings yield.

The new kid on the block

There has been much fuss around Apple Inc. (NASDAQ:AAPL)‘s buyback plan, but how much will it benefit shareholders?

Before buyback
Share price $457.00
EPS $42.26
Earnings Yield 9.25%
After tax cost of borrowing 2.97%
Number of outstanding shares 945,360,000
Planned buybacks 38,000,000

Figures for current stock buyback

At a closing price of $457 a share on May 11, Apple Inc. (NASDAQ:AAPL)’s earnings yield was 9.25%. The company borrowed $17 billion of differing maturities at an average yield of 2.97%, which will buy back 38 million shares at Friday’s closing price.

Assuming the company’s earnings remain constant, discounting interest, Apple Inc. (NASDAQ:AAPL)will earn $41.2 billion for fiscal 2013 and with the reduced number of shares in issue, Apple will earn $45.41 per share for the year, up around 7% thanks to the buyback.

After Buyback
Earnings after borrowing cost $41,200,000,000
Shares outstanding 907,360,000
EPS $45.41

Figures for current stock buyback

Apple’s earnings yield is significantly above the the company’s cost of borrowing, so earnings per share will be higher than the pre-purchase level. Additionally, with an earnings yield of 9.25% Apple Inc. (NASDAQ:AAPL) would appear to be undervalued when compared to the US 10-year, which currently yields 1.9%.

A tobacco company borrowing for buybacks

Is Lorillard Inc. (NYSE:LO)’s recent buyback program funded through debt going to provide a decent return for shareholders?

Before buyback
Share price $42.77
EPS $2.81
Earnings Yield 6.57%
After tax cost of borrowing 3.50%
Number of outstanding shares 391,050,000

Figures for current stock buyback

The figures here are from Lorillard’s 2012 results and the borrowing figures are based on the company’s $500 million debt issuance at the end of last year, for which the company is paying on average 3.5%. However, Lorillard’s stock appears to be more expensive than that of Apple with an earnings yield of 6.57%, double the rate that the company is borrowing at, indicating that the company’s borrowings will benefit shareholders, albeit to a lesser extent than Apple Inc. (NASDAQ:AAPL)’s.

After Buyback
Earnings after borrowing cost $1,081,440,972
Shares outstanding 379,420,000
EPS $2.85

Figures for current stock buyback

Assuming the company’s earnings remain constant, after deducting interest on the new debt, Lorillard’s earnings per share will grow 1.4% thanks to the buyback.

A debt binge

Lastly, let’s take a look at DIRECTV (NASDAQ:DTV), which has been borrowing heavily to finance buybacks during the past few years, but has it been worth it? The figures I use below are for the company’s 2011 buyback, which ended during 2012.

Before buyback
Share price $46.25
EPS $2.48
Earnings Yield 5.36%
After tax cost of borrowing 4.00%
Number of outstanding shares 886,000,000
Planned buybacks 134,000,000

Figures for 2011 re-purchase operations

DIRECTV (NASDAQ:DTV)’s buyback program has been running for five years and has been funded entirely through huge amounts of borrowing, which has had a knock on effect on the company’s cost of borrowing. Indeed, both Lorillard and Apple have been able to borrow at rates almost half that of their earnings yield. DIRECTV (NASDAQ:DTV), in comparison, is borrowing at a rate of 4%, compared to its earnings yield of 5.63% for 2011. That said, DIRECTV (NASDAQ:DTV) is still borrowing at a lesser rate than its earnings yield, signifying that shareholders will benefit from the buyback.

After Buyback
Earnings after borrowing cost $2,000,000,000
Shares outstanding 752,000,000
EPS $2.66

Figures for 2011 re-purchase operations

After the buyback, assuming earnings remained constant, DIRECTV (NASDAQ:DTV)’s EPS moved higher by 7.3%, an impressive rate of growth.

Conclusion

Earnings yield can be a useful way of finding out if a company is over/undervalued as compared to the market. It can also be a helpful way in calculating if a company is making the right decision in borrowing in order to return cash to shareholders  All the companies discussed above have plenty of flexibility in their earnings yield, but DIRECTV (NASDAQ:DTV) could be running close to trouble if its borrowing costs rise higher.

The article Earnings Yield and Evaluating Stock Buybacks Funded With Debt originally appeared on Fool.com and is written by Rupert Hargreaves

Copyright © 1995 – 2013 The Motley Fool, LLC. All rights reserved. The Motley Fool has a disclosure policy.

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