Creating shareholder value
There are a few main ways a company can create shareholder value with the cash it is generating. It can choose it put its cash towards internal growth initiatives, which could be in the form of new property & equipment that helps the company ramp up production, but could also be in the form of higher marketing expenses where the purpose is to acquire more customers. If these initiatives generate growth at a sufficient level, it can create shareholder value over time.
But not all companies have opportunities to put capital to work. Older companies in mature markets might have limited options to grow, and doesn’t see any real reason to invest in new capacity. There are also companies whose business model doesn’t require any real tangible, and where growth isn’t dependent on the capital expenditures of the company. Sometimes, companies have some internal growth opportunities but doesn’t need to reinvest all of the cash, only some of it.
All of these companies generate cash every year that has to be deployed in some way or another. Sure, they could choose to keep all of the cash within the company, but not many companies choose this option because it is often an ineffective use of capital. Instead, companies constantly have to weigh their options of what to do with the cash.
The main options
These are the main ways a company can allocate capital, excluding internal growth initiatives.
- Dividends. A company distributes excessive cash to shareholders, who are then able to reinvest the dividends they receive into other situations (or back into the same company if they wish). Dividends have historically been the most common way of returning cash to shareholders.
- Mergers and acquisitions. A company can choose to acquire other companies or merge with them in order to expand market share, diversify products, or enter new markets.
- Debt management. A company can choose to pay down existing debt, which would lower the company’s interest expenses and create more financial stability within the company. If the interest expense is high, a debt repayment may create shareholder value. Sometimes though, companies choose to add debt in order to increase the return on the shareholder’s equity.
- Share repurchases. In recent years, share repurchases, or buybacks has become the most popular way of returning cash to investors (in the U.S.), and there are many reasons why. I will expand on share buybacks below, and explain why I view it as the superior way of returning capital to investors.
Share buybacks: How the math works
When a company repurchases its own shares, it decreases the number of shares that trades in the market, which in turn increases the return of the existing shareholders. How it works is pretty simple:
Imagine a company that has 10 million shares outstanding. The company earns $100 million, which gives the company earnings of $10 per share (EPS). If the company repurchased 10% of the shares, it would have 9 million shares left, and assuming the company still earns $100 million, the earnings per share would increase to $11,11 since the earnings are now divided between a lesser number of shares. This way, an investor that previously earned $10 on each of his shares, now earns $11,11 instead.
The following table shows how the EPS would increase over a five-year period, assuming the earnings stay constant at $100 million.
| Year | Outstanding Shares | Shares Repurchased | EPS |
| 1 | 10,000,000 | 1,000,000 | $11.11 |
| 2 | 9,000,000 | 900 000 | $12.35 |
| 3 | 8,100,000 | 810 000 | $13.72 |
| 4 | 7,290,000 | 729 000 | $15.24 |
| 5 | 6,561,000 | 656 100 | $16.93 |
As the table shows, the EPS would have grown from $10 to almost 17$ over the five-year period, even when the earnings of the company stayed constant.
How do buybacks benefit the investor?
In the previous example, we assumed that the company bought back 10% of its share outstanding every year. This resulted in the EPS growing from $10 to $17. This was a rather oversimplified description of how buybacks work. In reality, the calculation is more complex. Since the company repurchases shares at fluctuating prices, the effectiveness of each buyback will vary. So, when calculating the effectiveness of buybacks, one has to include the valuation at which the company bought back their shares at.
Example: Imagine that a company earns $100 million per year. They have 10 million shares outstanding, and the price of each share is $100, giving the company a market cap of $1 billion. Let’s assume the company uses all of its $100 million to repurchase shares each year over a five-year period. Let’s also assume that the price of the shares stays constant. What will happen?
In the first year, the company will repurchase 1 million shares for $100 million, which will reduce the share count by 10% down to 9 million. In the second year, the company will repurchase shares for $100 million, but this time, since the company only has 9 million shares outstanding, the buyback in the second year will lower the share count by 11,11% (1/9 = 11,11%) The table below shows how the math works:
Year | Shares outstanding (Start of Year) | Shares repurchased | Shares outstanding (End of Year) | % of Shares Repurchased |
|---|---|---|---|---|
1 | 10,000,000 | 1,000,000 | 9,000,000 | 10.00% |
2 | 9,000,000 | 1,111,111 | 7,888,889 | 12.35% |
3 | 7,888,889 | 1,266,667 | 6,622,222 | 16.06% |
4 | 6,622,222 | 1,514,286 | 5,107,936 | 22.88% |
5 | 5,107,936 | 1,956,000 | 3,151,936 | 38.36% |
Since the share price stayed constant over the period while the share count decreased, the market cap will have gone down each year, thus allowing the company to repurchase an increasingly higher percentage of the shares outstanding. In this example, the share count at the end of the period will be roughly 3,15 million shares, down from 10 million at the start of the period. The EPS will have gone from $10 to roughly $31. In this case, the EPS essentially tripled even though the earnings of the company stayed constant at $100 million.
This is why buybacks are so attractive. If you are able to identify a company trading at a relatively low multiple (10x in this case), that you think will have steady earnings in the coming years, and where you think cash flows will be used to repurchase shares, you are looking at something very attractive. The logic is pretty simple. Either the stock price will increase over time to adjust for the lower share count, thus giving you a return in the price appreciation, or the company will get increasingly cheaper over time, giving the company (and you) the chance to purchase a larger and larger percentage of the company each year. In a way, when you invest in companies whose cash flows will be used to repurchase shares, you can actually be quite happy when the stock price declines, because you know that the stock buybacks will create even more value over time. The paper losses that you see in your account is actually an illusion, because there is a lot of value created “behind the scenes”.
More reasons why buybacks are attractive to investors
- Tax reasons. When a company distributes its earnings though dividends, investors that receive the dividends usually have to pay income taxes. This is true in the U.S. and many countries in Europe. When a company instead repurchases shares, this tax is avoided. Since 2022, companies have to pay a 1% excise tax on their buybacks, but this is nothing compared to the income taxes investors have to pay on dividends. When companies use their cash for buybacks instead of dividends, the compounding of value can continue without it being interrupted by tax payments on the way.
- Insight by management. Of course, the management of a company will know more about its own business than any other business. This means that the management of a company will be much better at identifying when their own stock is undervalued than when other companies are. The management can take advantage of this by buying back their own shares opportunistically at times of undervaluation. This way, they also avoid the risks associated with the acquisition of another company.
- Flexibility. Usually, when companies start paying dividends, investors begin to expect it, and even rely on it. There are therefore external pressures on companies that pay dividends which makes the management hesitant to cancel, or even lower their dividends. This is obviously bad, because it makes these companies unable to move quickly to capitalize on opportunities that arise. As contrast, share buyback programs gives companies more flexibility because investors don’t necessarily expect that the company should buy back shares at a steady pace. Whether a company repurchases shares for $500 million or $300 million in a given quarter doesn’t really matter much, but had the dividends of dividend paying company fluctuated that much, there would probably be an uprising on Wall Street.
When do buybacks destroy shareholder value?
As the points above show, buybacks can create a lot of shareholder value. But this is not always the case. Since 1997, the total amount of buybacks of U.S. based companies has exceeded the total dividends paid [1]. In other words, buybacks have become the new norm. The risk is that companies buy back their own stock on “automatic-mode”, which essentially means that they just spend whatever their free cash flow is that year to buy back shares, with no real thought as to whether or not it is actually creating value, just because it is said to be good for shareholders. My previous examples showed how buybacks create more shareholder value whenever the stock is cheaply priced. The reverse is also true; the higher the valuation of the stock, the less effective the buybacks. If companies use their free cash flow to repurchase shares at any price, it is inevitable that they will destroy shareholder value in periods of high valuations.
Some other ways buybacks can destroy shareholder value:
- Ignoring potential acquisitions: The company might be buying their own stock at 30 times earnings, when it has the option to buy a competitor at 12 times earnings. In that case, it is likely that the company is destroying value by not acquiring its competitor.
- Underinvestment in operations: There is also the risk that a company chooses to buy back their own shares instead of investing into their business. If the company underinvests in their operations over a long time, problems are sure to appear.
- Offsetting dilution: Nowadays, it is very common to compensate employees with stock options and other forms of stock-based compensation. This is especially common in software and tech companies. When cash flows are specifically used to offset the dilution caused by stock-based compensation, there is no real value created by the stock buybacks.
What the data shows
In the paper Examining Share Repurchasing and the S&P Buyback Indices in the U.S. Market published by S&P Global [1], the authors Liyu Zeng and Priscilla Luk give some insights into how share buybacks create shareholder value. The findings showed that buyback portfolios generated positive excess returns over the long term when compared to their benchmark indices in the U.S. market.
For example, the findings show that the S&P 500 Buyback Index outperformed the benchmark S&P 500 Index in 16 out of the 20 years leading up to December 31, 2019.
Over a 20-year period, the S&P 500 Buyback Index returned 11,5% on average, while the S&P 500 equal weighted index returned 9,3% on average. Note: The S&P 500 Buyback Index is an equally weighted index, which is why I compare it to the S&P 500 equally weighted index.
The paper notes that the announcement of a buyback program by a company resulted in a 3,5% average initial market reaction, but that the initial reaction often was an underreaction. The paper mentions what they call the “underreaction hypothesis”, which says that the market initially views buyback programs with skepticism, but that this eventually leads to outperformance in the stock. They mention an average of 12,1% abnormal buy-and-hold return in repurchasing firms over the four years following the announcement.
Conclusion
By now, I have made it clear that I love stock buybacks. But not always. It is important to analyze every situation and ask whether or not the buybacks will continue, if they will create value, if there are better options, if management is overly optimistic etc. I like to look for cheap companies with reliable cash flows, where management seem to be aware of their undervaluation and where they capitalize on it by buying back shares opportunistically. In my opinion, this is one of the best ways of finding stocks that will outperform over the long term, and the data seem to confirm this.
Sources:
1. S&P 500 Global. Examining Share Repurchasing and the S&P Buyback Indices in the U.S. Market. Authors Liyu Zeng and Priscilla Luk.
https://www.spglobal.com/spdji/en/documents/research/research-sp-examining-share-repurchases-and-the-sp-buyback-indices.pdf