Facebook Shareholders, Rejoice
Last week I said that the biggest risk to long-term investment success is not market crashes, it’s perpetually high prices.
Price is inversely correlated with future returns. The lower price you invest at, the higher your future returns, and vice-versa. Perpetually high prices never offer investors a chance to invest at levels that offer attractive expected future returns. It sounds obvious once you say it, but it doesn’t feel that way when your portfolio is a sea of red.
If you’re like me, you’re licking your wounds after Facebook’s shellacking in the market last week. But it doesn’t need to be that way. Instead, let’s take the opportunity to review an oversimplified for illustrative purposes example on why we should be rejoicing the opportunity the market has afforded us.
In last week’s earnings report, Facebook (NASDAQ: FB) disclosed that they had spent $45 billion on stock buybacks in 2021, repurchasing a total of 136 million shares for an average price of $329.49, which represents a P/E ratio of 25x 2021 earnings. The $45 billion spent on buybacks equaled 115% of last year’s free cash flow.
Let’s assume in our base case that the stock never crashed from there (narrator: it did), and stayed at a 25x P/E for the next 5 years. Let’s also assume that Zuck slows the pace of buybacks just a touch and only spends 100% of FCF on share repurchases each of the next 5 years (although with $48 billion cash on the balance sheet and no debt, he could do more if he wanted).
With no multiple expansion or contraction, our returns mirror the results of business plus the share reduction for a 14% compound annual return.
Not bad. Turns out Facebook wasn’t exactly expensive before the recent plunge.
Notice that in this scenario, Facebook (I refuse to call it “Meta Platforms”) repurchased 480 million shares over the next 5 years, or 17% of the company. Due in part to the lower denominator, 2026 earnings per share rises to $25.80 and at 25x earnings the stock price rises to $646.57.
Now let’s assume the bear case, otherwise known as reality. The stock contracts to a P/E multiple of 17x in 2022 — which has happened — and languishes there for 5 years before reverting to it’s previous (and, coincidentally, current market average) earnings multiple of 25x.
In this scenario, buybacks are more accretive to earnings per share and we earn a superior 16% compound annual return over 5 years despite the stock being down 37% in year 1 and not recovering to its previous highs until year 4.
For the same amount of money, Facebook repurchased 642 million shares (up from 480 million) or 24% of the company. EPS grows to $27.69 and the stock price rises to $693.99. But the path to get there didn’t feel very good.
2% more per year doesn’t seem like much (compounded over decades, it is) but it’s something, especially when we didn’t have to lift a finger to earn it.
But! Let’s assume we can lift a finger. Let’s assume we’re in our prime earning years and saving and investing fresh money in the stock market all the time, DCA style. In fact, our annual bonus was fortuitously timed with Facebook’s fateful earnings report and we had a chunk of cash to invest this week at Monday’s close of $220.18.
Just as in our bear case, the multiple languishes at 17x for years before reverting back to 25x in year 5.
Since we were able to buy low, our CAGR in this scenario is a whopping 26%.
Now, the reality in investing may not be as clean as these simple examples suggest (although sometimes it really is!) For one, a Facebook shareholder might have owned some stock before, and then decide to invest more now at lower prices, complicating your overall return calculation.
But the point is that long-term investment returns will be better if the earnings of the business are able to be reinvested at better rates of return (i.e. lower pries), everything else equal. This can be accomplished most obviously from an investor’s perspective through a business buying back it’s own stock, as we’ve shown above, or by investors reinvesting their dividends back into the stock, which functions in much the same way (albeit less tax efficient for the investor).
This is true even if you are not able to invest new money into a stock (or, the “stock market”) after a crash. And, if you are, then your long-term returns are turbocharged.
So, the next time a stock you own drops 25% in a day, just say to yourself “it’s okay, buybacks will be more accretive at these levels” like a totally normal person.
Disclosure: I own shares of FB
Disclaimer: nothing published in this newsletter is financial advice. The author may be long or short any of the securities or assets discussed at any time before or after publishing.