What Are Stock Buybacks? Do They Actually Create Value?
Stock buybacks, also known as share repurchases, occur when a company buys back its own shares from the marketplace. This action reduces the number of outstanding shares, effectively increasing the ownership stake of existing shareholders. The concept is straightforward: fewer shares mean that each remaining share represents a larger piece of the company's earnings and assets. Buybacks have the potential to create value for shareholders, but they can also destroy value if used inefficiently.
Buybacks can be executed through open market purchases, tender offers, or privately negotiated deals. Companies often announce buyback programs to signal confidence in their future prospects, believing that their stock is undervalued and that repurchasing shares is a wise investment.
Why Can Stock Buybacks Be Useful?
Returning Value to Shareholders: By repurchasing shares, companies can return excess cash to shareholders without the tax implications associated with dividends. Shareholders benefit from an increased ownership stake, potentially leading to higher stock prices.
Earnings Per Share (EPS) Enhancement: Reducing the number of outstanding shares can boost a company's EPS, making the stock more attractive to investors. This can lead to higher stock prices, benefiting both the company and its shareholders.
Flexibility: Unlike dividends, which represent a long-term commitment, buybacks provide companies with flexibility. They can be adjusted or suspended based on market conditions and the company's financial health.
Signaling Confidence: A buyback program often signals that management believes the company's stock is undervalued, instilling confidence in investors.
How Share Repurchases Can Boost EPS and Stock Prices
Stock buybacks can increase earnings per share (EPS) and other per-share metrics by reducing the number of shares outstanding, which can also have a direct impact on the stock’s price if the price-to-earnings (P/E) ratio remains constant.
For example, imagine a company with 100 million shares outstanding and a net income of $200 million. The EPS would be $2.00 ($200 million divided by 100 million shares). If the company decides to repurchase 20 million of its shares, the number of shares outstanding decreases to 80 million. Assuming the net income remains the same at $200 million, the EPS would increase to $2.50 ($200 million divided by 80 million shares).
Now, here’s how the stock price can increase — If the stock was trading at a P/E ratio of 15x before the buyback, the stock price would be $30 (EPS of $2.00 multiplied by the P/E ratio of 15x). After the buyback, with the EPS rising to $2.50 and the P/E ratio remaining at 15x, the new stock price would be $37.50 (EPS of $2.50 multiplied by the P/E ratio of 15x). This represents a 25% increase in the stock price, driven purely by the increase in EPS due to the buyback, assuming all other factors remain constant. This illustrates how buybacks can lead to an appreciation in stock price, benefiting existing shareholders.
When Stock Buybacks Can Be Misused
While stock buybacks can be a powerful tool, they can also be misused, especially when a company prioritizes buybacks over more productive uses of capital, such as reinvesting in its business.
High Valuations: If a company buys back shares when its stock is overvalued, it can destroy shareholder value instead of creating it. Essentially, the company is overpaying for its own stock, which can be a poor use of capital. For instance, let’s say you use our reverse DCF calculator to determine that a stock is very overvalued (and let’s assume your analysis is correct). Then, it likely wouldn’t be a good idea, at least from your point of view, for management to buy back shares. After all, if you wouldn’t buy the stock because it’s overvalued, then why should management do it?
Neglecting Growth Opportunities: Companies with ample cash reserves may be tempted to buy back shares instead of investing in research and development, expanding operations, or acquiring new businesses. This can lead to missed opportunities and stunted long-term growth.
Artificially Inflating Metrics: Some companies use buybacks to artificially inflate EPS and other financial metrics, making the company appear more profitable than it actually is. This can mislead investors and create a false sense of security.
Case Study of Successful Buybacks: Apple and Carl Icahn
One of the most notable examples of a successful stock buyback is Apple’s repurchase program in the early 2010s. Activist investor Carl Icahn was a vocal proponent of Apple’s buyback strategy, arguing that the company was undervalued and had a massive cash reserve that could be used to benefit shareholders.
Apple initiated a massive buyback program, repurchasing billions of dollars worth of its shares. This move significantly reduced the number of outstanding shares, thereby boosting the company's EPS and stock price. Over time, Apple’s stock price soared, unlocking substantial value for shareholders. Icahn eventually sold his stake in Apple for a significant profit, and the company’s buyback program is often cited as a textbook example of how buybacks can create shareholder value when executed under the right conditions.
Case Study: GE and Unsuccessful Buybacks
On the other hand, General Electric (GE) provides a cautionary tale of how buybacks can fail to deliver value. In the early 2010s, GE embarked on an aggressive share repurchase program, spending billions of dollars on buybacks. The company spent $24 billion on repurchases in 2 years. However, the company was grappling with deep-seated operational issues, declining profitability, and mounting debt.
Instead of addressing these problems, GE continued to repurchase shares, often at high valuations. This strategy did little to improve the company’s underlying business or its stock price. In the years that followed, GE's stock price plummeted, and the company was forced to slash its dividend and sell off assets to shore up its balance sheet. The buyback program, in hindsight, was a misallocation of resources that could have been better spent on revitalizing the business.
How to Find Companies That Are Buying Back Shares
Finding companies that buy back shares may seem complex for new investors, but it’s more simple than you’d think. For example, you can use a platform like Finbox and screen for stocks that buy back shares. Here’s an example of how to do this below.
Below, I’ve set up a basic screener to find me stocks with buyback yields of 5% to 20% (meaning that the amount of buybacks they’ve done in the past year is equal to 5-20% of the current market cap), and I’ve also set the minimum market cap to $10 billion. This is just a basic example, but it can get much more detailed than this. If you’d like to check out this screener, you can click here.
The Takeaway
Stock buybacks can be a powerful tool for returning value to shareholders and signaling confidence in a company's future. However, they must be executed judiciously, with a clear understanding of the company's valuation and growth prospects. When used appropriately, as in the case of Apple, buybacks can unlock significant value for shareholders. However, when misused, as seen with GE, they can exacerbate existing problems and destroy shareholder value. Companies must carefully weigh the benefits of buybacks against alternative uses of capital to ensure that they are truly acting in the best interests of their shareholders.
