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Importance of Stock Buybacks for Investors

Fajasy
Updated: January 14, 2021
Reading Time: 14 minutes

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In this article, I will discuss the importance of stock buybacks for investors, what positive or negative implications they may have for investors, and what things investors should look for when analyzing companies that do stock buybacks.

In short, a stock buyback, or share repurchase, is when a company purchases shares of their own company, generally from the public. This is a fairly efficient and common way for companies to pay out earnings to their shareholders, and is typically viewed as a positive thing by investors.

Unfortunately, stock buybacks can also destroy shareholder value and manipulate a company's figures to boost executive pay, or at the very least, expose bad management. So, although stock buybacks can be very beneficial to investors, this is not always the case over the long-term.

Therefore, this article will focus on understanding and differentiating between good and bad stock buybacks, and will explain how investors can apply this knowledge to companies they are analyzing today.

The Process of Stock Buybacks

The process of a stock buyback begins with companies having enough cash to purchase their own shares, either through borrowing money or with cash from their balance sheet, and then using one of the three methods below to repurchase shares:

  • Repurchase tender offers: When companies offer existing shareholders a specified stock price, typically at a higher price per share than the current stock price, and ask those interested to sell them their shares. This approach is more common for large stock buyback repurchases.
  • Open market purchases: When companies determine how much of the shares they're allowed to buy back, and then just buy them straight from the open market at the market price. This is the more common method overall, especially for smaller repurchases.
  • Privately negotiated repurchase: When firms buy back shares from large shareholders in the company at an agreed-upon price. Although uncommon, it's useful for consolidating and ridding of unwanted shareholders.

Whichever method the company decides to pursue, this will typically cost a lot of cash, which brings up the question on whether the company could have invested this cash elsewhere. This is the big question investors will need to be able to answer for stock buybacks, as we will later discuss.

How to Track Stock Buybacks

If you want to determine a company's stock buyback activity, look at their most recent cash flow statements, found in the 10-Q or 10-K annual reports. Here, if you look under "Cash Flow from Financing" or a similarly-named item, you may see line items that tell you how much the company has spent (or raised) by buying (or selling) their own shares.

The image above shows how much stock The Coca-Cola Company (KO) repurchased in 2019, 2018, and 2017 respectively (in millions). In this case, the line item is "Purchases of stock for treasury."

Typically, if you're following a company it will announce a stock buyback because they have an obligation under the U.S. Securities and Exchange Commission (SEC) to disclose such events and be fair and transparent to investors.

Company stock buyback programs are also reported on the "Investor Relations" section of their websites. Many times, you can crawl through their filings for more information as well. One free site to track upcoming stock buybacks is The Online Investor.

Now, if you want to look at the performance of U.S. companies that have purchased significant amounts of their own stock, you can look at the Invesco BuyBack Achievers ETF (PKW) -- the largest buyback ETF.

According to Invesco, this index is comprised of U.S. securities issued by corporations that have repurchased at least 5% or more of their outstanding shares in the last 12 months.

Its chart compared to the S&P 500 Index (^GSPC) is shown below:

An Introduction to Stock Buybacks

To recap, a stock buyback is when a company buys back its own shares. Although eliminating shares from the stock market may not appear productive, it actually increases how much other shareholders own of the company. Therefore, with fewer shares available to the public for purchase, this causes the available shares to always be more valuable, which typically causes the stock price to rise as well.

Warren Buffet, one of the world's greatest value investors, has an optimistic outlook on stock buybacks:

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"From the standpoint of existing shareholders, repurchases are always a plus."

— Warren Buffet in his 2016 letter.

You may see stock buybacks occurring more frequently with mature companies with lots of cash, such as those in the S&P 500, who may benefit more from issuing stock buybacks than reinvesting cash back into the company or making acquisitions. Therefore, it could be said that a company will only buyback shares when it doesn't have a better use for its cash. Regardless, in this case, a stock buyback would be an effective way to maximize shareholder value, instead of investing in a perhaps unnecessary venture.

The chart above shows stock buybacks from S&P 500 companies from 2000 to early-2020. Clearly, stock buybacks have been happening more and more in recent years, albeit in a bullish economy, but have dropped in 2020 due to the pandemic and brief recession. This increase in stock buybacks is also a big discussion itself.

Stock Buyback Examples

To understand how stock buybacks work in the real world and how their impact may differ, I'll walk through two example scenarios.

Basic Stock Buyback Example

Let's say you owned 100 shares of company XYZ with a current total share outstanding count of 1 million shares. This would mean you currently own 0.01% of the firm (100 / 1,000,000). Now, if the company were to buyback shares, say 100,000 worth of shares, the available shares on the market would fall to 900,000, and your ownership would grow to ~0.011% of the firm (100 / 900,000).

Although this may not seem like a lot, you gained more ownership of company XYZ without purchasing any additional shares, and your ownership of stock in company XYZ suddenly became more valuable, even if it was on a little.

Stock Buyback Impact Example

Now, let's say two identical companies had the same number of outstanding shares and initial starting stock price. Company A saw its stock price grow by $20, while Company B saw its stock price fall by $20.

If both companies wanted to issue a stock buyback of the same impact, the impact would vary quite drastically. In other words, because Company B has a lower stock price, management could purchase a lot more shares with the same capital than it could with Company A, hence making Company B shares more valuable. On the other hand, because the company is essentially paying a premium for shares with Company A, the buyback is not as effective as reducing the share count.

Stock Buybacks and Dividends

Companies are generally limited to these four things when it comes to spending cash:

  • Stock buybacks
  • Paying dividends
  • Reinvesting cash into the company
  • Making acquisitions

All four activities are typically carried out to maximize shareholder value, but buybacks and dividends, in particular, act to directly increase shareholder value. In fact, stock buybacks are considered to be equivalent to dividends in some regard, in the sense that companies spend cash to put profits back into the pockets of investors.

The chart above compares stock buybacks and dividends from companies on the S&P 500 from 1998-2018. As you can see, both stock buybacks and dividends are increasingly popular ways of giving back to shareholders.

Advantages of Stock Buybacks Over Dividends

The list below compares stock buybacks to issuing dividends, which on a broad scale may make little difference from the company's perspective because the same after-tax profits will be going to investors. However, in reality, there are several advantages investors should be aware of when a company decides to use a stock buyback over a dividend:

  • One-time cash returns: Stock buybacks are one-time returns of cash. Companies who have excess cash one year but are uncertain with their ability to generate cash in the future may opt into a stock repurchase over issuing dividends or a one-time dividend.
  • Flexibility: Stock buybacks are a far more flexible method of returning profits to shareholders than dividends. This is because share repurchase programs are discretionary, and companies can continue or stop buying back shares whenever they like without any real public reaction or investor panic. On the other hand, if a company were to reduce or cut its dividend altogether, this would likely send the company's stock price plummeting.
  • Increasing insider control: If insiders do not tender their shares back after a stock buyback, their ownership of the firm will have more value (and therefore greater control), because of the reduction in the number of outstanding shares. One could say this is a sign of bad management.
  • Offer tax advantages to stockholders: In relation to taxes, dividends are subject to double taxation. In other words, money is taxed at the corporate level through revenue generated from business operations (at capital gains rates), and then again when the investor receives it as income (at ordinary tax rates). But with stock buybacks, because money is not directly passing to investors, they are able to experience a similar benefit without being charged on a personal income tax level.
  • Stock buybacks directly increase value: Stock buybacks benefit those who are already shareholders in the company by making their shares more valuable, which usually increases the stock price. New investors therefore may not reap the full benefits. Moreover, although an issuance of dividends can increase company value and typically its stock price as well, dividends are never guaranteed and there's no guarantee that investors will continue to reinvest dividend returns back into the same company.

In closing, capital allocation is one of the most important responsibilities of an organization. So, if companies cannot find good acquisitions, or if they feel they have too much cash to continue to grow organically, reinvesting it back into the business may not provide the most value to their investors. In this case, a dividend or stock buyback would make a lot more sense.

Stock Buybacks and Earnings per Share (EPS)

By now, you should have a good understanding of stock buybacks and why investors love them, but their benefit goes past just increasing the value of existing shareholder stake. In fact, stock buybacks also improve the firm's financial ratios, in particular the price-to-earnings and earnings per share (EPS) ratios, which are important profitability stock gauge ratios.

Let's begin with an example to understand why EPS grows after a stock buyback.

The EPS formula is below:

EPS = Total earnings / Total outstanding shares

If a company earns $10 million a year in total earnings (net income) and this is split among 1 million outstanding shares to investors, the stock would have an EPS of $10 ($10,000,000 / 1,000,000). Now, if the company wanted to buy back 100,000 shares, only 900,000 publicly available shares would remain. With the same earnings figure, the EPS would then jump to ~$11.11 ($10,000,000 / 900,000). So, although the company did not earn any additional money, there are fewer outstanding shares which leads to a higher EPS figure.

The big assumption here is that earnings (net income) stays the same after a stock buyback, which is not always true. To determine which way net income changes, it's important that you ask and understand how stock buybacks are being funded. In other words, is the company you're analyzing using cash in the balance sheet to fund this stock buyback, or is the company borrowing money instead to initiate this particular stock buyback?

Answering these questions will provide you with a better scope of a company, the reasons for the stock buyback, and also how well you can trust its management team.

Stock Buyback Financed by Debt

Now, if a company were to borrow money to fund a stock buyback, this is obviously not ideal from an investors perspective, but it's also not always a clear "bad thing." Therefore, it's important that investors know how to distinguish whether a stock buyback financed by debt will lead to a higher or lower EPS figure, as discussed in this section.

Continuing off with the previous example, let's say the current stock price on the stock market is $50 per share, and their earnings ($10 million), EPS ($10) and shares outstanding (1 million) are all the same.

P/E ratio = Current stock price / EPS

If we find the price-to-earnings (P/E ratio) using the formula above, we will get a P/E of 5x ($50 / $10).

Earnings yield = EPS / Current stock price

Earnings yield = 1 / P/E ratio

However, if we reverse this math following one of the two formulas above, we get an earnings yield of 20% ($10 / $50). As you can see, this is just the inverse of the P/E ratio (1 / 5) and shows the relationship between a company's EPS to its current stock price.

The important thing here for investors is to compare this earnings yield percentage to the after-tax cost of debt to determine which way EPS will move after a company issues a stock buyback financed by debt:

  • Earnings yield > After-tax cost of debt = Higher EPS
  • Earnings yield = After-tax cost of debt: No change to EPS
  • Earnings yield < After-tax cost of debt: Lower EPS

The after-tax cost of debt is the amount of interest a company pays on debt, subtracting any income tax savings due to tax benefits.

Let's continue with the same example to understand this relationship. If the company we're analyzing wants to buy back 100,000 shares at the open market price of $50 per share, it will cost them $5 million (100,000 * $50). Now, if the company could borrow this $5 million at an after-tax cost of debt of 10%, their actual after-tax cost of debt would be $500,000 per year.

EPS after stock buyback = (Earnings - After-tax cost of debt) / Total shares outstanding after stock buyback

Finally, if we calculate the new EPS (using the formula above), with only 900,000 shares outstanding, the previous earnings (net income) figure of $10 million, and an after-tax cost of debt of $4.5 million, this would cause the EPS after the stock buyback to rise to ~$10.56 [(10,000,000 - 500,000) / 900,000].

The reason EPS is now higher ($10 vs. $10.56) is simply because the earnings yield (20%) is higher than the after-tax cost of debt (10%). This would also cause the P/E ratio to fall, given the new higher EPS number, which may be a sign of a stock at a relative bargain price.

In summary, what this shows is that if companies finance stock buybacks through debt, the price that the company pays for the stock buyback is of utmost importance.

For instance, because the company in this example paid $50 per share, they had an earnings yield of 20% and the EPS number grew. However, if they had to pay $110 instead, then their earnings yield would've shrunk to ~9.10% and their EPS would've fallen instead. In this case, assuming the same 10% after-tax cost of debt figure, the company would not have been as profitable, because they would have gotten their shares at a worse deal.

Stock Buybacks with Cash on Hand

In the more "normal" and responsible scenario where a company uses cash that it already has on its balance sheet to fund a stock buyback, the same concept discussed before applies. The problem here is that cash transactions can be a bit harder to quantify.

So, if we had our earnings yield of 20%, the question we have to ask is whether the cash was earning more than this 20% earnings yield figure after the stock buyback.

However, what makes cash earnings hard to quantify is that companies are often rather discrete and will not tell us what they are planning to do with cash on the balance sheet.

Therefore, the best solution I have found is to find the Cash EPS figure, a more conservative measure of cash flow and earnings performance that also happens to be less prone to accounting manipulation.

The Cash EPS formula is shown below:

Cash EPS = Operating cash flow / Shares outstanding

After you find the Cash EPS figure, compare this to the earnings yield to see how net income and EPS may change after a stock buyback:

  • If cash EPS > earnings yield = Both net income and EPS falls
  • If cash EPS= earnings yield = No change to net income or EPS
  • If cash EPS < earnings yield = Both net income and EPS rises

Regardless, much of the time EPS will grow because of a cash buyback, unlike a buyback financed by debt. Therefore, if a company uses cash to do a stock buyback, you can be pretty confident that this will lead to a higher EPS figure.

Leverage

Another small thing to keep in mind here is leverage, which is often measured through the debt-to-equity (D/E) ratio:

D/E ratio = Total liabilities / total shareholders' equity

So, if a company prior to a cash stock buyback has a financial leverage ratio of 1, then this will likely not be the case after a stock buyback. This is because when a stock buyback is done, assets fall due to cash being spent, and equity falls in the same amount to balance out the balance sheet (assets = liabilities + stockholders' equity). Ultimately, this will cause the financial leverage ratio of a company to rise, which technically means more risk to shareholders.

However, the point here is that companies with higher amounts of leverage will trade at smaller P/E ratios, all else being the same. And, as you may know, a lower P/E ratio suggests that investors are expecting slower growth, which may or may not be the actual case for the company that just issued a stock buyback.

Therefore, even though it's typical that EPS rises and P/E falls from a stock buyback, there's no guarantee that the stock price will as well... It all depends on the market and what it thinks of a company's potentially slower growth, higher profits, and higher risk.

Good and Bad Stock Buybacks

Stock buybacks are not always a good thing for investors. After all, stock buybacks use a lot of cash, and can therefore be seen as a waste of money.

In short, companies should only really be doing stock buybacks in the following three scenarios:

  • When reinvesting cash or making acquisitions may not be the most profitable option.
  • When the stock is actually undervalued and/or falling in price significantly.
  • When the company has cash on hand, or when the company does not have cash but can feasibly borrow at a low interest rate to buyback an undervalued stock, as previously discussed.

If the company you're analyzing does not meet one of these three scenarios, then it may be a sign of a bad management team that you may want to avoid investing in anytime soon, if ever.

To further elaborate, the list below provides scenarios in which you may be able to identify bad management and/or bad stock buybacks.

  • Inflated stock price: Management may buyback shares to drive stock price growth, even if the stock is not undervalued or its stock price has been growing. This may be a sign of an over-confident management team that believes their company's stock price can only go up in their current state, ignoring all fundamentals and biases.
  • High EPS: Management may buyback shares to increase the earnings-per-share (EPS) ratio, which is a measure of how profitable a company is. This may be done prior to an earnings announcement or a publicly available report to falsely improve the public's perception of the company.
  • Management compensation: In relation to the previous bullet, a company's management team can have its compensation tied to the company's EPS, which typically rises after a stock buyback. This can be a a sign of a corrupt management team making decisions based on self-interest, which can harm the company's operations and stakeholders altogether.
  • Regular stock buybacks: If a company regularly issues stock buybacks, and not when the stock is undervalued or significantly falling in price, then this can be a sign of an under-confident management team that is not willing to invest its cash elsewhere to drive actual firm growth. Obviously, without firm growth the company is at risk of failing.
  • Stock buybacks financed by debt: As previously discussed, when a company borrows money to finance its stock buybacks because it doesn't have cash on hand to do so, especially with a falling or negative net income figure, this will cause the company to be more leveraged. If a company cannot manage its debt payments, then it's at risk of failing as well.

Clearly, stock buybacks are not always ideal for investors. Therefore, if you have ownership in a company that is issuing a stock buyback, it's important that you understand why this is happening. If you have reason to believe the stock buyback is unnecessary, then this may warrant further research or just selling off your ownership stake altogether.

The Bottom Line

At the end of the day, stock buybacks are generally viewed as a positive thing by investors. After all, if a company has the cash and is willing to invest in itself, why shouldn't other investors follow?

Better yet, if you purchased a stock because you thought it was undervalued, and then the company issues a stock buyback, you would be more than happy to see your stake in the company rise and your valuation to be somewhat substantiated, not to mention the stock price appreciation that would likely follow.

Even so, stock buybacks are not always a good thing, with some companies abusing stock buybacks and not utilizing their cash effectively. Often times, these companies will fail due to artificially-inflated stock prices, irresponsible uses of debt to finance stock buybacks, and bad management teams that serve their self-interests before those of shareholders -- among other reasons.

In closing, if you already understand a company's business model, its management team, and how it operates in different markets, you'd be fairly quick to assess whether a company is justified in doing its stock buybacks or not. As value investors in particular, this should be easy to judge, and in many cases I'd rather invest in a company diluting share ownership for a good reason than a company buying back its shares for a bad one.

Disclaimer: Because the information presented here is based on my own personal opinion, knowledge, and experience, it should not be considered professional finance investment or tax advice. The ideas and strategies that I provide should never be used without first assessing your own personal/financial situation, or without consulting a financial and/or tax professional.
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