Payouts to Shareholders  655 Nevertheless, two myths about share repurchases seem to persist among analysts and managers. The first is that managers can create value by repur- chasing shares when they are undervalued.38 Managers have inside infor- mation and could be in a better position than investors to assess when the company’s shares are undervalued in the stock market and to buy these at the right time. Buying the undervalued shares would create value for those share- holders who hold on to them. However, the empirical evidence shows that companies rarely pick the right time to buy back shares.39 For 2001 through 2010, a majority of the S&P 500 companies bought back shares when prices were high, and few bought shares when prices were low. In fact, the timing of share repurchases by more than three-quarters of S&P 500 companies resulted in lower shareholder returns than a simple strategy of equally distributed re- purchases over time would have generated (see Exhibit 33.13). The second myth is that repurchases create value simply because they in- crease earnings per share (EPS). The implicit assumption is that the price-to- earnings ratio (P/E) remains constant. As explained in Chapter 3, the logic is flawed: when share repurchases are financed with excess cash or new debt, a company’s EPS indeed goes up, simply because the P/E for cash or debt is higher than for the company’s equity.40 However, after the repurchase, the EXHIBIT 33.12  Valuation Unrelated to Payout Level or Payout Mix Median enterprise-value-to-EBITDA multiple,1 end of year 2007 Payout Level,2 payout as % of total net income 0–65 14 65–95 14 95–130 14 >130 16 All companies 14 Repurchases only4 20 Payout Mix,3 dividends as % of payout 0–20 13 20–40 14 40–65 16 65–100 14 All companies 14 1 Median multiple of nonfinancial companies in S&P 500 index. 2 Payout defined as dividends paid plus share repurchases, 2002–2007. 3 Average proportional share of dividends in total payout, 2002–2007. 4 This category’s higher level results from a higher proportion of fast-growing companies relative to other categories. Source: Corporate Performance Analytics by McKinsey. 38 See B. Jiang and T. Koller, “The Savvy Executive’s Guide to Buying Back Shares,” McKinsey on Fi- nance, no. 41 (2011): 14–17. 39 Some academic studies have concluded that companies do, in fact, time their repurchases well. Those findings, however, are driven primarily by smaller companies that make a one-time decision to repur- chase shares. Once those smaller companies are excluded, the smart-timing effect disappears. 40 We define the P/E here in general terms as the market value of an asset or liability divided by its after-tax earnings contribution. The P/Es for cash and debt are the inverse of their after-tax interest rates and are typically higher than for the company’s equity. 656  Capital Structure, Dividends, and Share Repurchases equity P/E will be lower because the company’s leverage has increased.41 The increase in EPS does not lead to value creation for shareholders, because it is exactly offset by the decline in P/E. Of course, in a large sample of companies and over long periods of time, there is always an apparent correlation between EPS growth and total shareholder returns (TSR), but that is entirely attribut- able to revenue growth and return on capital. After controlling for these value drivers, there is no correlation between a company’s share repurchase inten- sity and its shareholder returns.42 The real value creation from share repurchases can only be assessed in comparison with alternative cash deployments, such as business investments, debt repayments, cash holdings, or dividend payments. Contrary to common beliefs, EPS and P/Es provide no guidance in making the assessment. Alter- native deployments of cash have a mechanical impact on these metrics that does not necessarily correlate with value creation. This is illustrated in Exhibit 33.14 with a hypothetical company that generates net operating profit after EXHIBIT 33.13  Relative Performance of Timing Share Repurchases Number of companies per TSR cohort,1 2004–2010 < –12.5 > –12.5 <–10.0 > –10.0 <–7.5 > –7.5 <–5.0 > –5.0 <–2.5 TSR cohorts based on 3-year TSR vs. TSR if shares purchased evenly across periods, percentage points > 0.0 < 2.5 > 2.5 < 5.0 > 5.0 < 7.5 > 7.5 < 10.0 > 12.5 > 10.0 < 12.5 > –2.5 < 0.0 Median –3.0 16 12 12 9 26 25 2 2 1 1 0 29 1 Based on 135 S&P 500 companies that repurchased shares from 2004 to 2010. TSR is total shareholder returns. Source: Corporate Performance Analytics by McKinsey. 41 There are two ways to explain the P/E decline. The first considers the P/E for a company’s equity as a weighted average of the P/Es for its operations, cash, and debt. Paying out cash reduces the weight of the relatively high P/E for cash and therefore lowers the P/E for a company’s equity. Attracting debt increases the negative weight of its relatively high P/E and lowers the equity P/E as well. The second explanation says that with higher leverage, shareholder risk has increased. This drives up the cost of equity and leads to a lower P/E multiple. 42 See O. Ezekoye, T. Koller, and A. Mittal, “How Share Repurchases Boost Earnings without Improving Returns,” McKinsey on Finance, no. 58 (2016): 15–24.