When Buybacks Create Value

Why this matters

Dividends and Buybacks showed that a buyback raises earnings per share by spreading the same profit over fewer shares. That's true of every buyback, good or bad, which is why it tells you nothing. This lesson is about the part that varies: whether the shareholders who didn't sell ended up better or worse off.

The price decides

When a company buys its own shares, it's using shareholders' money to buy out some of their partners. If it pays less than the shares are worth, the remaining owners gain at the sellers' expense. If it pays more, the sellers gain at theirs.

A company is worth $1,000 million by a careful estimate, including $100 million of spare cash. It has 20 million shares, so each is worth $50. It earns $60 million a year, or $3.00 a share. It spends the $100 million on its own shares. The small amount of interest lost on the cash is ignored.

	Bought at $40	Bought at $50	Bought at $62.50
Shares bought	2.5 million	2.0 million	1.6 million
Shares remaining	17.5 million	18.0 million	18.4 million
Value of the company afterward	$900 million	$900 million	$900 million
Value per remaining share	$51.43	$50.00	$48.91
Change for those who stay	+2.9%	none	−2.2%
Earnings per share	$3.43	$3.33	$3.26

Earnings per share rise in all three columns. Value per share rises in one, is unchanged in another, and falls in the third. At $40, the sellers gave up $10 a share on 2.5 million shares, $25 million in all, and the remaining shareholders gained exactly that. At $62.50, the sellers collected $20 million more than their shares were worth, and the remaining shareholders paid it.

In his 2011 letter to shareholders, Warren Buffett put the test as two conditions. The company should have ample funds for the operating and liquidity needs of its business, and its shares should be selling at a material discount to a conservative estimate of what the business is worth. He added that shareholders who stay are hurt unless shares are bought below that value, and that with buybacks as with acquisitions, "what is smart at one price is dumb at another."¹

The difficulty is that nobody knows the value precisely. Part 4 put STU Corp's value between about $29 and $67 a share, with a base case of $44.69, against a price of $50. A buyback at $50 helps the remaining shareholders if the bull case is right and hurts them if the base case is. Management has to make the same uncertain judgment as any investor, and it's judging its own work.

Why companies buy back shares

A survey of 384 finance chiefs and treasurers, published in 2003, found that managers view buybacks as more flexible than dividends, and that they like to repurchase when they feel their shares are undervalued and in an effort to affect earnings per share.² Those are three different motives, and they aren't equally good for shareholders.

• Returning spare cash without a commitment. A sensible reason. A buyback can be paused in a bad year without the alarm a dividend cut causes, as Dividend Policy described.
• Buying shares that are cheap. The best reason, when management is right about the value.
• Raising earnings per share. A reason that has nothing to do with value. It's strongest where executive pay depends on that figure, which Management Incentives and Corporate Governance returns to.

Buybacks that don't shrink the share count

Companies that pay employees partly in shares, as Stock-Based Compensation covered, add to their share count every year. Buybacks can be used to take those shares back out.

	Shares, millions
At the start	100.0
Bought back, at an average of $50, for $300 million	(6.0)
Issued to employees	5.0
At the end	99.0

The company can say truthfully that it returned $300 million to shareholders. The share count fell by 1%. The other $250 million bought back shares the company had just handed out, which makes it a cash cost of paying employees more than a return of capital. Each remaining shareholder's slice of the business is 1% larger, not 6%.

The number to look at is the change in the share count, not the amount spent.

Buybacks paid for with debt

Capital Structure imagined STU Corp borrowing $310 million to buy back shares. Earnings per share would rise, and its interest cover would fall from more than 13 times to about 3. A buyback funded from spare cash returns money the business doesn't need. A buyback funded by borrowing changes how risky the company is. It may still be a reasonable decision for a steady business with very little debt. It should be judged as a decision to borrow, with the tests from the last three lessons.

Timing

Cash is most plentiful when business is strong and scarcest in a downturn. A company that spends whatever it can afford each year will buy the most shares in good times and the fewest in bad ones, whatever the price. A company that judges value first will sometimes do the opposite, buying heavily when its shares have fallen and holding back when they've risen. The pattern of purchases against the share price over several years shows which kind of company you're looking at.

Where to check

• The buyback table. In its quarterly and annual reports, a company must show for each month the number of shares it bought, the average price paid, how many were bought under publicly announced programs, and how much may still be bought under them.³ Compare the prices paid with the share price since and with your own estimate of value.
• Announcements against purchases. An announced program sets a maximum. The last column of the table shows how much of it hasn't been used.
• The share count. Take the diluted share count from the income statement over five years. If it hasn't fallen much, the buybacks have mostly offset new shares.
• The cash flow statement. The financing section shows the cash spent on buybacks next to any new borrowing.
• The method. Purchases can be made gradually in the open market or in one step through a tender offer.

There's also a tax. Since 2023, US companies whose shares trade on a stock market have paid a federal tax of 1% of the value of the shares they repurchase in a year, reduced by the value of shares they issue in that year, including shares issued to employees.⁴⁵

Key takeaways

• A buyback below what the shares are worth moves value to the shareholders who stay. Above it, value moves to those who sell.
• Earnings per share rise either way, so they can't show whether a buyback was a good one.
• Look at the change in the share count. Buyback spending can go mostly to offsetting shares issued to employees.
• A buyback funded with debt is a decision to borrow and should be judged as one.
• Companies report the shares bought each month and the average price paid.

Check your understanding

By your estimate a company is worth $600 million, or $20 a share on its 30 million shares. It spends $60 million of that buying back shares at $30. What happens to the value of each remaining share?

1. It rises, since the same business is now divided among fewer shares.
2. It falls to about $19.29, since $30 was paid for shares worth $20.
3. It stays at $20, since a buyback swaps cash for shares of equal value.

A company's earnings per share grew 8% a year for three years. Net income was flat. The share count fell about 7% a year through buybacks funded by new borrowing. What happened?

1. The business didn't grow. Fewer shares and more debt produced the rise.
2. The business grew 8% a year, since earnings per share is what counts.
3. The shares got safer, since each one has a bigger claim on the profit.

What's next

A buyback is a purchase of a business the management knows well. Mergers and Acquisitions turns to purchases of businesses it knows less well.