Increasing Earnings Per Share with Share Repurchases
Investing Lesson 4 - Analyzing an Income Statement
Just as stock options, warrants, and convertible preferred issues can dilute your ownership in a company, share repurchase plans can increase your ownership by reducing the number of shares outstanding. Below is an updated and expanded version of an article I published more than a decade ago that talks about how share repurchases, stock buybacks, and stock repurchases can increase your wealth if they are managed wisely.
Stock Buybacks - The Golden Egg of Shareholder Value
All investors have no doubt heard of corporations authorizing share buyback programs. Even if you don't know what they are or how they work, you at least understand that they are a good thing (in most situations). Here are three important truths about these programs - and most importantly, how they make your portfolio grow.
Principle 1: Overall growth in firm profits isn't nearly as important as the growth in earnings per share
Too often, you'll hear leading financial publications and broadcasts talking about the overall growth rate of a company. While this number is very important in the long run, it is not the all-important factor in deciding how fast your equity in the company will grow. Growth in the diluted earnings per share is.
A simplified example may help. Let's look at a fictional company:
Eggshell Candies, Inc.
$50 per share
100,000 shares outstanding
Market Capitalization: $5,000,000
This year, the company made a profit of $1 million dollars.
In this example, each share equals .001% of ownership in the company. [100% divided by 100,000 shares.]
Management is upset by the company's performance because it sold the exact same amount of candy this year as it did last year.
That means the growth rate is 0%! The executives want to do something to make the shareholders money because of the disappointing performance this year, so one of them suggests a stock buyback program. The others immediately agree. The company will use the $1 million profit it made this year to buy stock in itself.
The very next day, the CEO goes and takes the $1 million dollars out of the bank and buys 20,000 shares of stock in his company. (Remember it is trading at $50 a share according to the information above.) Immediately, he takes them to the Board of Directors, and they vote to destroy those shares so that they no longer exist. This means that now there are only 80,000 shares of Eggshell Candies in existence instead of the original 100,000. (To be more specific, the board may decide to retire the shares or, if it is permitted and it finds desirable, it may put them in a special section of the balance sheet called treasury stock).
What does that mean to you? Well, each share you own no longer represents .001% of the company... it 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 didn't grow this year, you still made a twenty-five percent increase on your investment. This leads to the second principle.
Principle 2: When a company reduces the amount of shares outstanding, each of your shares becomes more valuable and represents a greater percentage of equity in the business.
If a shareholder-friendly management such as this one is kept in place, it is possible that someday there may only be 5 shares of the company, each worth one million dollars. When putting together your portfolio, you should seek out businesses that engage in these sort of pro-shareholder practices and hold on to them as long as the fundamentals remain sound. One of the best examples is the Washington Post, which was at one time only $5 to $10 a share. It has traded as high as $650 over the past few years.
That is long term value!
Principle 3: Stock buybacks are not good if the company pays too much for its own stock
Even though stock buybacks and share repurchases can be huge sources of long-term profit for investors, they are actually harmful if a company pays more for its stock than it is worth or uses the money it cannot afford to spend. In an overpriced market, it would be foolish for management to purchase equity at all, even in itself. Instead, the company should put the money into assets that can be easily converted back into cash. This way, when the market moves the other way and is trading below its true value, shares of the company can be brought back up at a discount, giving shareholders maximum benefit.
Remember, "even the best investment in the world isn't a good investment if you pay too much for it".
This page is part of Investing Lesson 4 - How to Read an Income Statement. To go back to the beginning, see the Table of Contents.