Latest / How Canadian Markets Work / Episode 50: Splits and Buybacks

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Episode 50: Splits and Buybacks · How Canadian Markets Work

0:00
You know, when you go to a magic show and you
0:03
watch a magician saw an assistant in half, there's
0:05
this, like, implicit contract. Right, you know
0:08
it's a trick. You know it's a trick. You're paying
0:11
for the illusion. You know there are trap doors
0:13
and mirrors, and you suspend your disbelief because,
0:17
well, it's entertaining. But what happens when
0:20
that exact same illusion happens inside your
0:23
Berkridge account? Yeah, that's when it stops
0:25
being funny. Exactly. So today we are doing a
0:28
deep dive into two specific corporate maneuvers
0:32
that frankly they often sound like absolute financial
0:35
alchemy to the average investor. Yeah we're talking
0:38
about stock splits and share buybacks and you
0:40
know I'm looking at your wall of financial charts
0:42
right now and I really need you to translate
0:44
all that data into plain English for me because
0:47
we are pulling from a massive stack of analytical
0:51
notes on the mechanics of Canadian financial
0:53
markets today. I will do my best it's a lot of
0:56
data but it's important. It is. Our mission for
0:59
this deep dive is pretty simple. When a stock
1:01
you own suddenly doubles in quantity or a company
1:04
starts throwing cash at its own shares, we need
1:07
to know if we are actually gaining value or if
1:10
we're just falling for a brilliantly executed
1:13
marketing campaign. It's a really vital distinction
1:16
to make, honestly. Because financial media tends
1:19
to talk about these two tools in the exact same
1:23
breath. Right. Like they're just two flavors
1:25
of the same corporate action. But mechanically,
1:28
they do completely different things. OK. One
1:30
is an exercise in pure psychology. And the other
1:34
literally alters the fundamental mathematical
1:37
reality of the underlying business. OK, let's
1:39
unpack this. I want to start with the maneuver
1:41
that grabs all the flashy headlines, but from
1:43
what I understand seems to change the least,
1:45
the stock split. Yes. the classic stock split.
1:48
Walk me through what is actually happening behind
1:50
the curtain when a company announces this. So
1:52
the math of a stock split is entirely straightforward,
1:55
even if the market's reaction to it isn't. Imagine
1:59
you own a stake in a company and the board of
2:02
directors announces a two -for -one stock split.
2:05
OK. Before the split happens, let's say you own
2:08
100 shares and they are trading on the open market
2:11
at $60 each. Right. So my total investment is
2:14
sitting at $6 ,000. 100 shares, 60 bucks a piece,
2:19
6 grand total. Exactly. When the split is executed,
2:22
the company essentially just runs a simple multiplication
2:25
and division equation. OK. They multiply your
2:28
share count by 2, but they simultaneously divide
2:30
the share price by 2. So I wake up the next morning.
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And you now have 200 shares in your account.
2:36
Yeah. But they are priced at $30 each. Right.
2:39
200 times 30 is still exactly $6 ,000. So my
2:43
total value is identical. Completely identical.
2:46
Your fractional ownership of the overall company
2:48
is identical. The company hasn't sold more products,
2:51
they haven't cut costs, and their assets are
2:53
exactly the same. So literally nothing economic
2:55
has happened. Literally nothing. I mean, it sounds
2:58
like the exact corporate equivalent of ordering
3:01
a pizza and asking the place to cut it into eight
3:03
slices instead of four. That is the exact perfect
3:07
analogy. Yes. Because I don't magically get more
3:09
food just because there are more slices in the
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box. I just have like smaller pieces of the exact
3:15
same pizza. Right. So. If it is completely economically
3:18
meaningless, I have to ask, why do corporate
3:21
boards even bother doing it? I mean, it has to
3:24
cost administrative time and money to execute,
3:26
right? It does. But historically, the primary
3:29
reason was purely about accessibility for the
3:32
retail investor. How so? Well, decades ago, small
3:36
investors used to buy shares in what were called
3:39
board lots. Board lots? I've actually never heard
3:41
of a board lot. Why was that a requirement? It
3:44
was basically a mechanical constraint of the
3:46
old paper based trading systems. It was just
3:48
too inefficient to trade single paper shares.
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So a board law was typically a standardized bundle
3:53
of 100 shares. Oh, wow. So if a company's stock
3:56
had performed incredibly well over a decade and
3:59
was now sitting at, say, $800 a share. Right.
4:03
A single board lot of 100 shares would cost an
4:06
investor $80 ,000. Exactly. That effectively
4:09
priced out the normal everyday retail investor
4:13
from ever buying into the company. Yeah, I don't
4:16
have 80 grand just sitting around for one stock.
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No people don't. So a split was a way to bring
4:21
that share price back down to earth so the average
4:23
person could afford a lot. But doesn't technology
4:26
completely solve that today? Like, I feel like
4:29
I can pull out my phone right now on a modern
4:31
brokerage app and buy $10 worth of an $800 stock.
4:36
You absolutely can. Fractional shares have largely
4:39
solved that accessibility problem, making that
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historical justification, you know, much less
4:44
relevant today. Right. But that brings us to
4:47
the second and far more persistent reason. Companies
4:50
still do this. Which is? Psychological signaling.
4:53
Ah. A company typically only splits its stock
4:56
after a prolonged period of success where the
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price has risen significantly, right? Yeah, that
5:01
makes sense. So announcing a split is an implicit
5:04
statement from management to the market. They
5:07
are broadcasting a message that says, our stock
5:10
price has gone up and we are splitting it because
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we confidently expect it to keep rising. So it's
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essentially confidence disguised as a corporate
5:17
action. That is the core of it, yeah. Studies
5:20
have historically shown these small positive
5:24
price bumps around the announcement of a split.
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But that bump isn't because the split inherently
5:29
created any Tangible value because the pizza
5:32
is the same size because the pizza is the same
5:34
size It is just the market reacting favorably
5:37
to the signal of management's confidence the
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split itself is pure marketing. Pure marketing.
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Wow. But there is a dark mirror to this in the
5:46
source material, isn't there? Yes. The reverse
5:48
split. Oh, the reverse split. It operates on
5:49
the exact same mechanical principles, just in
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the opposite direction. OK, break that down for
5:54
me. Where a standard split multiplies the shares
5:57
and divides the price, a reverse split divides
5:59
the shares and multiplies the price. Let's say
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a struggling company has 10 shares trading at
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$0 .50 each. They might execute a one for 10
6:07
reverse split. Those 10 shares are consolidated
6:10
into one single share, which is now priced at
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$5. OK, so the total value is still exactly $5
6:17
either way. If a standard split is a victory
6:20
lap, why would a struggling company force their
6:23
share price up artificially like that? What's
6:25
the point? It's almost always to maintain exchange
6:28
listing requirements. Listing requirements. Yeah,
6:31
major stock exchanges like the Toronto Stock
6:33
Exchange or the New York Stock Exchange have
6:35
minimum price limits. If your stock trades below
6:38
a dollar for a prolonged period, the exchange
6:41
will threaten to delist you and remove you from
6:43
their platform. Wait, why do the exchanges care
6:45
if a stock is trading at 20 cents or $5, as long
6:48
as people are buying and selling it? It really
6:50
comes down to prestige and protecting investors.
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Okay. Exchanges want to maintain a reputation
6:55
for hosting quality businesses. Stocks trading
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for pennies are notoriously susceptible to, um...
7:02
market manipulation, pump -and -jump schemes,
7:04
and extreme volatility. Right, penny stocks.
7:07
Exactly. The minimum price limit is a barrier
7:10
to entry. So a company trading at 20 cents might
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execute a reverse split just to artificially
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boost the share price back over that $1 threshold
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so they can stay on the prestigious exchange.
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Meaning, a reverse split is almost always a massive
7:25
red flag. Oh, massive. It's a symptom of bad
7:28
news that has already happened. The company has
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lost so much value, they have to mechanically
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manipulate the price just to survive in the public
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markets. It tells you everything you need to
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know about the health of the business without
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looking at a single financial statement. Alright,
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so splits, whether they're forward or reverse,
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are just psychological. They are the magician's
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mirror. But what happens when a company actually
7:50
alters its financial math? Let's move from the
7:53
illusion of value to the mechanical manufacturer
7:56
of value. I like how you put that. I want to
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talk about the share buyback. How does this actually
8:00
work? So a share buyback or a share repurchase
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is when a company uses its own surplus cash to
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go out into the open market, purchase its own
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shares from willing sellers, and then permanently
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cancel them. They just cancel them. Literally
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destroyed and removed from circulation. Which
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means there are fewer slices of the pizza overall.
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So if I hold onto my shares, I own a bigger piece
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of the pie. That is the fundamental mechanism.
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Because there are fewer shares in existence,
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everyone who didn't sell now owns a proportionally
8:30
larger percentage of the company and its future
8:33
profits. OK. Let's walk through the math on this
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slowly because this is where the alchemy actually
8:37
happens, I think. Yes. Let's ground this in the
8:39
specific example from our sources. Walk me through
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the numbers. OK, let's construct a hypothetical
8:44
company. This company has exactly 100 million
8:49
shares outstanding in the market, and those shares
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are currently trading at $40 each. Got it. 100
8:56
million shares, 40 bucks a pop. At the end of
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the year, this company reports a net income like
9:02
your actual bottom line profit. of $200 million.
9:05
OK. Now, the market loves to look at a metric
9:08
called earnings per share, or EPS. You calculate
9:11
this by dividing that $200 million in profit
9:14
by the 100 million shares. Which gives you an
9:17
EPS of exactly $2. Exactly. $2 of earnings for
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every single share out there I'm following. Now,
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imagine the company has $100 million in surplus
9:27
cash sitting in a bank account. And management
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decides to use it for a buyback. OK. They take
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that 100 million, go into the market, and buy
9:36
shares at that market price of $40. That allows
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them to purchase and then retire 2 .5 million
9:44
shares. Leaving them with 97 .5 million shares
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left in existence. Right. Now, run the earnings
9:50
per share math again for the following year,
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assuming the business performs exactly the same.
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Here's where it gets really interesting. The
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company's net income is still exactly $200 million,
10:00
right? Right. The underlying business didn't
10:01
get any more profitable. But if I divide that
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same $200 million by the new lower share count
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of $97 .5 million, the earnings per share rises
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to $2 .05. The company's EPS just mechanically
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rose by 2 .5%. Wait a minute. That sounds like
10:19
a scam. I know, right? Are you telling me regulators
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just let companies manipulate their math like
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this? They didn't sell more products. They didn't
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cut costs. They didn't invent anything new. They
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just shrank the denominator to make themselves
10:31
look more profitable on paper. Well, it isn't
10:34
a scam. It is just the mathematical reality of
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having fewer owners sharing the same pool of
10:39
profits. OK, yeah. But what is fascinating is
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how the market responds to that mathematical
10:43
reality. The market generally values a company
10:47
based on a price to earnings, or P .E. multiple.
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Hold on. Remind me how the P .E. multiple works
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in this context. Think of the P .E. multiple
10:55
as a gauge of how much investors are willing
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to pay today for $1 of the company's current
11:01
earnings. OK. If a company has a P .E. of 20,
11:04
it means the market is willing to pay $20 for
11:06
every $1 of earnings the company generates. It's
11:10
a measure of sentiment and, you know, growth
11:12
expectations. OK, so if the P .E. stays the same,
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what happens? If the market continues to assign
11:17
a P .E. multiple of 20 to our company, let's
11:20
look at the price. Before the buyback, 20 times
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the $2 EPS gave us a $40 share price. Right.
11:27
After the buyback, 20 times the new $2 .05 EPS
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gives us a $41 share price. Wow. The stock goes
11:36
up simply because the share count went down.
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But wait. If executive compensation, like their
11:43
massive bonuses, is often tied to hitting specific
11:47
EPS targets or hitting a specific share price,
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aren't those executives highly conflicted? Oh,
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absolutely. Aren't they heavily incentivized
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to just dump corporate cash into buybacks to
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trigger their own bonuses, even if it's a terrible
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long -term move for the business? This raises
12:03
an incredibly important point, and it is honestly
12:06
the sharpest criticism of buybacks in the financial
12:08
world. A buyback is not inherent magic. At its
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core, it is simply an investment decision. It
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is management deciding to invest corporate cash
12:17
into their own stock rather than, say, building
12:19
a new factory or hiring more staff. Right. It's
12:21
capital allocation. Exactly. And like any investment,
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it is only a good decision if the price they
12:26
pay is right. Explain that. How does the price
12:29
determine if it's a good or bad buyback? Let's
12:31
talk about intrinsic value versus market price.
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Intrinsic value is what a business is fundamentally
12:38
worth based on a cold, hard calculation of his
12:42
future cash flows. Okay. It is like knowing the
12:46
true Kelley Blue Book value of a car. The market
12:49
price, however, is just what the dealer is asking
12:52
on any given day driven by hype or panic. Okay,
12:55
I like that analogy. Suppose the fundamental
12:57
intrinsic value of our company is $60 a share.
13:01
But the market is currently in a panic, undervaluing
13:04
it, so it's trading at $40. If the company takes
13:07
its cash and buys back shares at $40, they're
13:10
essentially buying a $60 asset for $40. They're
13:13
buying a dollar for $0 .67. Which is an amazing
13:15
deal. It is a phenomenal capital allocation decision.
13:18
In that scenario, immense value is created and
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the remaining shareholders absolutely gain from
13:24
the transaction. Because they bought low. Because
13:26
they bought low. But let's reverse it. Suppose
13:28
the true intrinsic value of the company is only
13:31
$30 a share, but the market is currently caught
13:34
up in a speculative bubble and the stock is trading
13:36
at $40. Oh no, they are overpaying. Massively
13:40
overpaying. If management uses corporate cash
13:43
to buy back shares at $40, they are paying $40
13:47
for an asset fundamentally only worth $30. Ouch.
13:50
In that scenario, capital is actively destroyed,
13:54
the money goes out the door, the remaining shareholders
13:56
lose fundamental value, and management has effectively
13:59
lit shareholder cash on fire. So it completely
14:02
hinges on management's ability to accurately
14:05
value their own company and be disciplined enough
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to only buy when it's cheap? Yes. Which sounds
14:10
great in an economics textbook. But what does
14:13
the data actually say? Do companies actually
14:15
buy low and sell high? The empirical reality
14:18
found in the source material is deeply unflattering.
14:22
Really? Historically, corporate boards are terrible
14:24
at timing their own stock. The data shows that
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buyback activity tends to peak when markets are
14:29
roaring, the economy is hot, and profits are
14:31
high. Meaning they buy the most heavily at elevated,
14:34
often overvalued prices. Exactly. And then during
14:38
economic downturns, when their shares are actually
14:41
cheap and trading well below intrinsic value,
14:44
executives get scared, they hoard cash, and buybacks
14:47
stop completely. So they do the exact opposite
14:50
of what they should do. Pretty much. They buy
14:52
at the absolute top of the market and stop buying
14:55
at the bottom. It's the exact same behavioral
14:57
flaw that retail investors are constantly mocked
15:00
for, you know, buying the hype and panicking
15:02
in the crash, except it is being executed by
15:05
professional executives using billions of dollars
15:08
of corporate cash. It is a profound irony of
15:10
modern finance. Wow. OK, so we've established
15:13
that a buyback is a capital allocation decision.
15:16
And really, it is the main alternative to paying
15:18
a dividend, right? Right. If a company has surplus
15:21
cash, they either hand it to you as a cash dividend
15:23
or they use it to buy back shares. So if I'm
15:26
looking at my portfolio right now here in Canada,
15:28
which one should I be rooting for, a dividend
15:31
or a buyback? The answer to that relies heavily
15:33
on the tax code, specifically the tax reality.
15:37
for a Canadian investor. OK, let's break down
15:39
that divide. Dividends versus buybacks. Let's
15:42
start with dividends. If a company pays you a
15:44
dividend, that is a direct distribution of cash
15:47
into your brokerage account. In Canada, that
15:51
is a taxable event in the year you receive it.
15:54
Makes sense. Now, the Canadian government recognizes
15:57
that the corporation already paid tax on that
15:59
money before they handed it to you. So eligible
16:02
Canadian dividends get favorable treatment through
16:05
the Canadian dividend tax credit to avoid double
16:08
taxation. Wait, pause for a second. Double taxation.
16:12
Reconstructing corporate tax. Walk me through
16:14
that really simply. Sure. Imagine you own a small
16:17
business. The business makes a profit and pays
16:19
corporate income tax to the government. Okay.
16:22
the business pays the remaining cash out to you
16:24
as the owner. If the government taxed you fully
16:27
on that cash again, that same dollar would be
16:30
taxed twice. Right. The dividend tax credit is
16:33
essentially a mathematical formula the government
16:35
uses to recognize the tax the corporation already
16:37
paid. So you personally pay a lower tax rate
16:40
on that dividend than you would on something
16:42
like interest from a savings account. Got it.
16:45
It softens the blow, but it is still a blow.
16:48
Precisely. It is an elegant system, but crucially,
16:52
it still forces a taxable event on you right
16:55
now. If you hold that stock in a standard, non
16:59
-registered taxable account, you owe taxes this
17:02
year on that cash, whether you needed the cash
17:04
or not. But a buyback avoids this. Entirely.
17:07
When a company executes a buyback, you do not
17:09
receive any cash. The value simply accrues within
17:13
the share price itself, because you now own a
17:15
larger percentage of the company. Right. So if
17:17
you don't sell your shares, A buyback is not
17:20
taxable to you at all. The game just sits there,
17:23
completely sheltered, growing over time. The
17:25
tax is deferred indefinitely. You are only taxed
17:28
on the capital gene when you choose to sell the
17:29
stock, on your own timeline. Wow. For a taxable
17:32
investor in a non -registered account, that tax
17:35
deferral is a massive mathematical advantage.
17:37
It allows your capital to compound year after
17:39
year without the government taking a slice every
17:42
single time a dividend is paid out. That sounds
17:44
like a clear, undeniably huge win for buybacks,
17:47
but you keep mentioning non -registered accounts.
17:49
What about registered accounts, like a tax -free
17:51
savings account or an RRSP? And here is the account
17:55
location trap that catches so many investors.
17:59
At the end of the day, the account you hold the
18:02
stock in is what actually decides if this is
18:04
a win for you. If you hold your shares inside
18:07
a registered account like a TFSA, that entire
18:10
deferral advantage of the buyback vanishes completely.
18:14
Because a TFSA is already a tax sheltered bubble.
18:17
Exactly. Inside a TFSA, you don't pay tax on
18:20
dividends and you don't pay tax on capital gains.
18:23
So deferring the tax through a buyback has absolutely
18:26
zero value to you. Furthermore, that Canadian
18:29
dividend tax credit we talked about. It is worth
18:31
precisely nothing inside a TFSA, because there
18:34
is no tax liability to credit against. So if
18:37
I'm holding a stock in my TFSA, I might actually
18:39
prefer the cash dividend today. Yes, you might.
18:42
Because I receive it completely tax free, and
18:44
I can immediately take that cash and reinvest
18:46
it in a different company if I want to, rather
18:48
than trusting management to time a buyback perfectly.
18:50
You've hit the nail on the head. The tax wrapper
18:53
surrounding the asset dictates which corporate
18:55
action actually puts you in a better financial
18:57
position. OK. Let's pull all of this together.
19:00
We've covered a huge amount of ground on these
19:02
corporate maneuvers. To summarize, stock splits
19:06
are just pizza slices. Yes. It is pure psychology
19:09
and marketing to make the shares look more accessible
19:12
with zero economic change to the underlying business.
19:16
A completely frictionless illusion. Buybacks,
19:18
on the other hand, actively shrink the denominator.
19:22
They flatter the earnings per share by reducing
19:24
the share count, which mechanically makes the
19:26
company look more profitable on a per share basis.
19:29
And whether that buyback creates or destroys
19:31
value depends entirely on one thing. intrinsic
19:35
value. Buying undervalued stock is brilliant,
19:38
and buying overvalued stock destroys capital.
19:41
And as we saw, history shows management is notoriously
19:43
bad at knowing the difference. Right. And finally,
19:46
your own personal tax setup dictates your reality.
19:48
In a Canadian non -registered account, buybacks
19:51
offer incredible tax deferral. In a TFSA or RSP,
19:55
you might just want the cash. Exactly. And if
19:57
we connect all of this to the bigger picture,
20:00
the sources highlight one major warning sign
20:02
listeners really need to watch out for. We've
20:05
talked about buybacks funded by surplus cash.
20:08
But in a low interest rate environment, companies
20:11
sometimes do something incredibly reckless. Oh,
20:13
boy. They fund buybacks with debt. They actually
20:17
borrow money from a bank just to buy their own
20:19
stock. Yes. And that fundamentally changes the
20:22
risk profile of the business. I mean, I would
20:25
think so. Returning organic surplus cash that
20:28
the business generated from selling products
20:29
is one thing. But taking out loans to shrink
20:32
the share count is artificially increasing the
20:35
financial leverage of the company. Right. It
20:37
amplifies the returns when things are going perfectly.
20:40
But leverage heavily amplifies the downside if
20:43
the business hits a rough patch. If a company
20:45
is taking on debt to buy back shares at peak
20:47
market prices, they are putting the entire enterprise
20:50
at severe risk just to engineer a higher EPS.
20:54
That is a terrifying thought. It brings us right
20:56
back to the magician, doesn't it? Yep, it does.
20:59
You always have to watch what the other hand
21:00
is doing. While management is flashing the rising
21:03
share price in your face, They might be quietly
21:06
loading the balance sheet with toxic debt in
21:08
the background. You have to read the actual financial
21:11
statements, not just the glowing press release.
21:13
Which brings me to a final puzzle to mull over,
21:16
based on our sources. Let's call it the announcement
21:19
versus reality trap. Okay. Imagine a company
21:23
proudly announces a massive multi -billion dollar
21:26
share repurchase program. The financial news
21:29
anchors are thrilled. The stock pops on the opening
21:32
bell. But I want you to go look at the actual
21:35
share count of that company over a five -year
21:37
period. The reality of the balance sheet often
21:39
tells a very different story than the headline.
21:41
Right. You might find that despite billions of
21:44
dollars being spent, the total share count barely
21:47
falls at all. Yeah. Sometimes it even goes up.
21:50
Why? Because some companies use buybacks simply
21:52
to mop up the massive dilution they're causing
21:55
by handing out millions of new shares as employee
21:57
compensation. They're running on a treadmill.
22:00
They are taking shareholder cash to buy shares
22:02
in the open market simply to offset the new shares
22:05
they are printing for their own executives. Exactly.
22:08
The announcement of the buyback is just marketing.
22:11
It's the puff of smoke on the stage. The actual
22:14
share count on the balance sheet is the undeniable
22:16
fact. So the next time a company you own announces
22:19
a corporate magic trick, don't just clap for
22:22
the illusion. Go check the real share counts
22:24
in your own portfolio. Make sure they aren't
22:26
sawing your fundamental value in half. Perfectly
22:29
said. Thanks for joining us for this deep dive.
22:31
We'll see you next time.