Discovered WAYN two months ago thanks to my friend Makram (thanks man). Where Are You Now? or WAYN is a cool tool for the travelling youth: you may basically check out or receive weekly reports on who’s coming to your location. Great for keeping track of your friends going around the world, or for spotting potential dating targets from Japan or Los Angeles (I’m currently blogging from Paris).

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“Message from Jeremy: For those new to Tech IT Easy who could obviously not remember the initial announcement, I have invited my friend and fellow Alexandre Lucas to help me try to provide you, dear readership, with everyday better analyses on software, telecom & Internet trends. Alex’s mission statement basically is to go further into the details, from both a financial and a strategic angle. Alex, the floor is now yours…”

Following Jeremy’s post on Yahoo! and the discussion, I wanted to provide a purely financial explanation of the share buy-back announced by Yahoo!.

1. Foreword: valuation

Valuation of High-Tech/Web companies is based on two pillars:

(i) the “objective” analysis based on market and industry figures and their neutral interpretation, which give rise to the modelling of scenarios (bearish, base, bullish) by the valuator, and

(ii) the “subjective” suggestions, called the “Equity Story”, which could be interpreted as a focus on the “bullish” scenario alone, instead of taking into account all potential scenarios and making a compounded average.

Valuation gives the market value of what financiers call the “left side” of the Balance Sheet, in other words, the Assets. Then, the managers of the company decide how to optimise the financing of the capital required to pay for these assets. It implies an arbitrage between Debt and Equity type financing products, depending on market requirements/prices. This is the optimisation of the “right side” of the balance sheet, i.e. the financial structure.

2. Yahoo! – Possible interpretations of the share buy-back

A. Classical Interpretations

1. Buy-backs as arbitrage between Equity & Debt

In finance, there is a classical way of interpreting the share buy-back. According a traditional viewpoint, a share buy-back is an optimisation of the financial structure, i.e. an arbitrage between Equity and Debt.

As a manager, you may estimate that the shares of your company are either undervalued or overvalued, depending on the expectations of the market regarding the realisation of the business plan. If you believe that they are undervalued, it means that buying a share of the company, you buy futures cash flows cheaper than what they would be worth given the risk of the business. If they are overvalued, you are overpaying future cash flows.

Depending on your analysis of the situation, if the capital structure of the company is optimal (assuming such a structure exists), a variation of the value of the company’s shares on the stock market creates an arbitrage opportunity between debt and equity.

When the management is presenting a capital increase, it tries to convince people that their business plan is going to realise a “bullish” scenario to make people buy shares at a higher price that what it would be worth if the market believed that the “base” scenario would be realised. When the company is doing a share buy-back, it is doing the opposite, having failed to persuade the market that its business plan is viable: it buys cheap future cash flows. They can do so by raising debt, thus exchanging debt for equity. Often, they do this because they have a better knowledge of the future than the rest of the market, i.e. their behaviour is close to an insider’s trade.

2. Buys-backs as a strategic tool (others)

Another classical interpretation would be that the management is trying to prevent share price from dropping, protecting itself against hedge-funds activity or managing some ownership issues.

B. Managing strategy differences between shareholders

1. Basics

This buy back could however be a solution to a discrepancy in the strategy between shareholders regarding the exposure of their equity to upside/downside potential of the company.

Let’s assume that there are two categories of shareholders of a company: a majority which wants to increase the exposure of their equity to the upside potential of the company’s activity (A) and others who are willing to exit were this exposure increased (B). A way to manage the exit of B from their shareholding without affecting the share price is to implement a buy-back.

When a company buys its own shares, these are destroyed according to national securities regulations to prevent self-control. Therefore, the market capitalisation of the company is decreased by the amount of equity bought.

2. Proof: Modelling

The consequence of a buy back is an increased sensitivity of the market capitalisation to the variations in the cash flows from operations.

Let’s assume a company which has a market Equity value of $70 and a market value of its Bonds of $50, totalling $120. Let’s also assume that this company has $20 in cash and that its future cash flows from operations are valued at $100, totalling $120.

In this case, a change in the operating cash flow resulting in a variation of 1% of the value of the assets lowers the value of the equity by $1, i.e. 1/70 = 1.43% (assuming debt is not sensitive to such changes).

Now let’s assume a buy back of $20 worth of shares. All things being equal, it will reduce the market capitalisation by $20, bringing the market capitalisation down to $50. The sensitivity of the market capitalisation to a change in the value of assets of is now 1/50 = 2%.

3. Implications of a share buy back on risk/return profile of the Equity

i) Equity is now more risky….

The equity being more sensitive to a change in operations following a share buy-back, investors should ask for a higher return on equity (which is now more risky), thus reducing the market capitalisation.

ii) … but more profitable

However, the return on assets is now higher than before (assuming that the yield on Cash & Equivalents is lower than the free cash flow yield).

In other words, before the share buy-back, the company has $120 worth of assets with total yield on assets of 11% [5%*$20(yield on cash) + 12%*$100(yield on assets) = $1 + $12 = $13]. Assuming a cost of debt of 5%, the cost of debt is $2.5 p.a. Therefore, the free cash flow to equity is $10.5, i.e. a RoE of 15%.

Following the share buy back, all cash has been spent to buy shares. Therefore, the free cash flow to equity is now $9.5 with equity down to $50. The RoE is now 19%.

3. Conclusion

Yahoo!’s motives are probably mixed and have been discussed among representatives of the shareholders. However, even tough I don’t know the company well, I believe that the buy-back’s main reason was a widening gap between the investments implemented and the cash generated, which resulted in the building up of a pile of useless cash.

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