By: Tom Vilord
Share buybacks occur when a company uses some of its excess cash to repurchase outstanding shares. If the company can’t identify a better way to invest that excess cash, they may decide the best use for that money is to buy back shares. It is management’s duty to maximize shareholder value, and if done correctly, this can be a huge way to accomplish that goal.
Some of the reasons a company will chose to do this is because the stock is trading at a big discount. There could be a few reasons that the company has been out of favor, resulting in a drop big enough to create a discounted stock price. For example, Target was out of favor a few years ago because of the data breach that affected their customers, Coca Cola was briefly discounted when they missed their quarterly earnings due to lower demand overseas, Cummins was out of favor in 2015 because their entire industry was doing poorly, Under Armour is slightly discounted now because of an overreaction to news that their sales growth has slowed down slightly, etc. During these times when a stock is trading at a discount to their intrinsic value, makes a great opportunity for management to step in, buy these discounted shares, and improve value for the shareholders.
In addition to buying shares at a discount, another potential positive outcome that could result in a share buyback is that it reduces the number of shares in the market which gives each existing shareholder a larger percentage of the total number of shares outstanding. Let’s say a company has 100 shares and we own 5 of those shares, then we own 5% of the company as well as 5% of the voting rights. If the company buys back 20 shares, and I still own my original 5 shares, now my ownership of that company increases to 6.25% (5 shares / 80 outstanding shares = 6.25%).
Also, this could result in a huge EPS boost. If a company had 1,000,000 in earnings and there were 250,000 outstanding shares, then their EPS is $4. If they did not earn 1 extra dollar the following year, but they bought back 35,000 of those outstanding shares, this would reduce their outstanding shares to 215,000. By doing this, they improved their EPS to $4.65 (1mm / 215k). This share buyback increased their EPS by 16.27% in one year simply by buying back shares from the marketplace. This could be a nice long term value to shareholders if the company stock is purchased at a bargain and the value of the company is continuing to grow.
When the Earning improve, this could also help lower the PE ratio. If a stock was at $60 before the buyback, when the EPS was $4, this would give us a PE of 15. If the stock was at $60 and EPS improved to $4.65 because of the buyback, the PE Ratio gets reduced to 12.90.
Since companies buy back shares with cash, and cash is listed as an asset, this will reduce the number of assets on the balance sheet which actually increases Return on Assets or ROA.
These are some of the reasons that buybacks could be a positive move for management. Unfortunately, not all managers are good managers. Some are clueless and some are not shareholder friendly. If they are clueless, they could be buying back shares at price that doesn’t represent a bargain price, and as value investors, we do not buy shares unless they are at a discount and neither should management.
If management is not shareholder friendly, they could be doing this simply to boost EPS in the short term. If the company is not improving their fundamental value, then the initial pop in EPS will be short lived. If a manager is doing this to fool investors, then this share buyback strategy will backfire.
Another way this could hurt shareholders would be if the company is issuing debt to buy back shares, aka leverage. If they drain their cash to buy shares or don’t have cash and issue debt to buy back shares to boost earnings, that could bite them in the butt if they don’t have growing cash flows to pay down its debt.
Sometimes cash is king. As of December 2016, I am still down from my original purchase of GILD. The mistake I made was that it wasn’t at a cheap enough discount when I bought it and I bought it because I couldn’t find anything better to invest in at the time. Stupid Stupid Stupid mistake, but I learned from it. If a buyback is only happening because there are no other places for management to invest their excess cash, then they are doing the shareholders a disservice. A good management team is good at identifying ways to invest that cash effectively, and if for some reason they can’t, they would never do a buyback at an unattractive price just for the sake of doing something with the cash. Sit on it until something attractive is identified and only when that happens should the cash be used.
So are buybacks good or bad? If the company is truly a great business that is growing, but in the short term is at a discount for some reason that isn’t a long term issue, then this could create a lot of value for the shareholders. Other than that, I don’t see a good reason to do a share buyback.