What are Share buy-backs?
Buying back shares
Sometimes a company has surplus funds that it does not need for operations. It can use those funds to expand its operations and attempt to earn an acceptable return or it can distribute them to stockholders. One way of distributing funds to shareholders is to have a share buy back, wherein the company buys back some of its shares from existing stockholders.
Share buy-back Example
Company A has 100 shares issued and makes a profit of $50. This means a shareholder is getting a return of 50 cents a share ($50/100). This is the Earnings per Share or EPS. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $7.50.
Suppose that the company buy back 25 shares. A shareholder who retains their shares now earns 67 cents ($50/75) on each share held. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $10.
Buying back shares for the right reasons
Warren Buffett likes companies that buy back their shares if they do so for the right reasons, and if they pay less than the intrinsic value of the share. The right reasons would be that a company is buying back their shares at an attractive current price.
Warren Buffett on buybacks
In 1999 during the Dot Com Boom buybacks were being used for the wrong reasons, Warren Buffett said this:
Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason, to pump up or support the stock price. The shareholder who chooses to sell today, of course, is benefited by any buyer, whatever his origin or motives. But the continuing shareholder is penalised by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.
When a company should buy back shares
A company can add value to its shares by buying some of them back:
- where it has surplus funds;
- where it can buy them back at a price below intrinsic value.
A buyback can be a much more tax efficient mannerism of returning capital to shareholders than a dividend and allows remaining shareholders to share in a larger piece of the pie.
An outstanding example of the value of buying back shares in located in Warren Buffett 2011 Letter to the Shareholders.
IBM Example from Warren Buffett
Indeed, I can think of no major company that has had better financial management, a skill that has materially increased the gains enjoyed by IBM shareholders. The company has used debt wisely, made value-adding acquisitions almost exclusively for cash and aggressively repurchased its own stock.
Today, IBM has 1.16 billion shares outstanding, of which we own about 63.9 million or 5.5%. Naturally, what happens to the company’s earnings over the next five years is of enormous importance to us. Beyond that, the company will likely spend $50 billion or so in those years to repurchase shares. Our quiz for the day: What should a long-term shareholder, such as Berkshire, cheer for during that period? I won’t keep you in suspense. We should wish for IBM’s stock price to languish throughout the five years. Let’s do the math. If IBM’s stock price averages, say, $200 during the period, the company will acquire 250 million shares for its $50 billion. There would consequently be 910 million shares outstanding, and we would own about 7% of the company. If the stock conversely sells for an average of $300 during the five-year period, IBM will acquire only 167 million shares. That would leave about 990 million shares outstanding after five years, of which we would own 6.5%.
If IBM were to earn, say, $20 billion in the fifth year, our share of those earnings would be a full $100 million greater under the “disappointing” scenario of a lower stock price than they would have been at the higher price. At some later point our shares would be worth perhaps $1.5 billion more than if the “high-price” repurchase scenario had taken place.
The logic is simple: If you are going to be a net buyer of stocks in the future, either directly with your own money or indirectly (through your ownership of a company that is repurchasing shares), you are hurt when stocks rise. You benefit when stocks swoon.
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