Principles of Stock Buyback Programs

Explaining stock buybacks and how they affect earnings per share

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Through stock buyback programs (also known as share repurchase programs), companies buy back shares of their own stock at market price to retain ownership. Doing so reduces the number of shares outstanding and increases the ownership stake of remaining stockholders. All else being equal, these programs should boost earnings per share (EPS). Here are three important principles for these programs.

Overall Growth vs. Growth in Earnings per Share

A company's decision to buy back its own stock is not based on the overall growth in profits. Instead, companies look at stock buybacks when they're considering how to increase EPS. The latter is the all-important factor that can determine how fast equity in the company will grow.

A simplified example may help. Let's say that Eggshell Candies, Inc., (a fictional company) has a market capitalization of $5 million (100,000 shares outstanding multiplied by $50 per share). Each share equals .001% of ownership in the company (100% divided by 100,000 shares). Let's say you own just one share.

This year, Eggshell Candies made a profit of $1 million, but management is upset by the company's performance because the growth rate was 0% (the company sold roughly the same amount of candy and made the same amount of profit this year as it did last year). To address this disappointing performance, and to make sure that shareholders make money, management decides to use this year's $1 million profit to buy back shares in the company.

With this plan in mind, the CEO goes out the next morning, takes $1 million out of the bank, and buys 20,000 shares of Eggshell Candies at $50 per share. The CEO then takes the issue to the board of directors, where a vote approves a plan to destroy the 20,000 shares (to be more specific, the board may decide to retire the shares or, if it is permitted and desirable, the board may put them in a special section of the balance sheet called treasury stock). This means that now there are only 80,000 shares of Eggshell Candies in existence, instead of the original 100,000.

What does that mean to you as an average shareholder? Well, each share you own no longer represents .001% of the company. It now represents .00125%. That's a 25% increase in value per share. The next day you wake up and discover that your stock in Eggshell is now worth $62.50 per share instead of $50. Even though the company's overall growth was 0% this year, individual shares gained value, and you made a 25% increase in your investment.

Reducing Shares Boosts EPS

When a company reduces the number of shares outstanding, each of your shares becomes more valuable and represents a greater percentage of equity in the business. It's akin to cutting the same pie with thicker slices. There isn't more pie available, but it's being split up among fewer pieces. In the corporate world, this "pie" includes all the benefits of holding a stock: company ownership, earnings per share, stock value, and more.

This attitude of seeking to increase the slice of pie for existing shareholders is known as "a shareholder-friendly management style." When putting together your portfolio, it can be lucrative to seek out businesses that engage in these sorts of pro-shareholder practices. Hold onto the stock as long as the fundamentals remain sound, and your shares are likely to grow significantly in value.

Benefits Are Contingent on an Attractive Stock Price

In the example above, shares were priced at $50, and there's an expectation that $50 is a fair price for the stock. Eggshell Candies wasn't hitting all-time stock market highs. The price wasn't overly volatile.

Stock buybacks are not good if the company pays too much for its stock. Stock buybacks and share repurchases can be huge sources of long-term profit for investors. However, they are actually harmful if a company pays more for its stock than it is worth, or if the company uses money it cannot afford for buybacks.

In an overpriced market, it would be foolish for management to purchase stocks at all, even its own stock. Instead, the company should put the money into assets that can be easily converted back into cash. Then, when the market moves the other way and shares trade below its true value, the company can buy back shares at a discount, giving shareholders maximum benefit.

Keep this old saying in mind: "Even the best investment in the world isn't a good investment if you pay too much for it."

Criticisms of Stock Buyback Programs

While share buybacks are generally a good thing for existing shareholders, they have not always been met with universal applause.

For example, the Tax Cuts and Jobs Act of 2017 significantly slashed corporate tax rates, putting a lot of money back in corporate coffers. Many companies began using these newly available funds to buy back shares of their own stock. In December 2018, just before the end of the first year under the new tax law, U.S. companies announced that they had spent more than $1 trillion on stock buybacks.

If you owned stock at this time, you likely experienced a boost to your portfolio. However, Gallup polls released September 2019 suggest that just 55% of Americans own any stock, and that ratio has been fairly consistent in Gallup polls since 2010. That means nearly half of Americans experienced no benefit from the tax cut buybacks.

Critics would rather see that $1 trillion spent in a way that benefits a larger number of people, such as investing in research and development, hiring workers, opening new locations, boosting employee salaries, or improving health and retirement benefits.