Every Acquisition Should Have to Beat a Stock Buyback

When I ran corporate development at Teradyne, a publicly traded maker of the equipment that tests semiconductor chips, every acquisition we brought to the board carried a slide comparing the deal with a stock buyback. We used that slide on every deal, and I saw the same comparison at other public companies.

We used it because of how investors see a large, mature public company. A company that spends $1 billion on an acquisition could have spent the same $1 billion buying back its own shares, and investors judge every deal against that choice. They want to know whether the deal adds to earnings per share.

So before anything else, management had to answer the question “Why grow at all?” For a public company, answering that means showing that the deal is a better use of the cash than giving it back to shareholders.

A buyback looks like the safe choice

A buyback is easy to like, because the math is simple and, on paper, the company takes no risk. Say the stock trades at $10 a share and the company spends $1 billion buying back 10% of its shares. Earnings have not changed but are now divided among fewer shares, so the stock should trade at about $11.

The people closest to the decision like that result. Shareholders see the price rise, and management likes it even more, because its performance targets and stock options are tied to the share price.

The costs are easy to overlook. The company spends its cash, and in the worst case it borrows to pay for the buyback. The cash spent on a buyback does not go into new product lines or factory expansion.

The buyback gain often fades

The $11 price is right only if the price-to-earnings multiple stays where it was, so that investors pay the same for each dollar of earnings after the buyback as before. The multiple is the one number the market sets by judgment. Investors read a buyback as a sign that the company has no better use for its capital, and as a short-term move with no growth behind it, so they lower the multiple.

The share count goes down and the price goes up, and then the multiple comes down. The finance team that ran the numbers is left asking why investors reacted badly to a move that was supposed to be safe.

The deal has to win on earnings alone

Our slide assumed no change in the multiple. We gave the buyback its full $11 and gave the acquisition no credit for any lift in how the market might value the company. The slide then asked one question: would $1 billion spent on the deal produce more earnings than the same $1 billion spent on shares?

If buying back 10% of the shares lifts earnings per share by about 11%, the acquisition has to add more than that. If it cannot, the buyback is the better use of the money. If management cannot show that a deal beats the buyback, the deal should not go forward.

Forecasts can miss on both sides

Acquisitions often fail to produce the earnings their models promised, and a deal beats the buyback on a slide only if the forecast behind it is right. That is a fair objection to the forecast, and the test still applies. An acquired business is supposed to generate earnings. If management cannot show it beating the buyback even on its own projections, the deal has no case.

Neither side of the comparison is certain. The stock reaches $11 after a buyback only if investors leave the multiple alone, and they often do not.

Growth can raise the multiple

When a company uses even a small deal to enter a more interesting market, more analysts may start covering it, and a little more investor interest can raise the multiple sharply. Take a company that finds it could sell its product into the AI ecosystem. It invests modestly, grows that business, and can show the growth. On its next earnings call, it tells investors it has started supplying that market.

Its multiple can climb steeply because investors now see a growth story, and a true one. They can watch the new business grow, which gives them a reason to buy the stock. A company that only rebrands itself as an AI company gives investors nothing to watch, and over the long term the company that can show growth often has the better story.

Investors stop valuing the company as a deep-value stock expected to grow a little at low risk and start valuing it as a stock with a growth component, using different measures.

We never put that lift on our slide because it’s impossible to predict or quantify. The deal had to beat the buyback on earnings alone, and any rise in the multiple was a bonus.

Put the buyback slide in front of the board

A board that does not see a buyback comparison approves acquisitions without knowing whether the company’s own shares were the better purchase. Before voting on the next deal, the board should ask management for three things:

• The buyback comparison. Show what the same cash would do for earnings per share if spent on the company’s own shares.
• No credit for the multiple. Make the deal beat the buyback on earnings alone, and treat any rise in the multiple as upside.
• An answer to “Why grow at all?” Explain why this use of the money beats giving it back to shareholders.

If management can supply all three, the deal deserves a vote. If it cannot, the cash belongs back with shareholders.