Buybacks are an important part of the investing world. Yet, many people misunderstand them. The S&P 500 – the largest 500 profitable businesses publicly traded in the United States – spent a collective $795 billion on buybacks in 2023 and $922 billion in 2022.

Otherwise known as share repurchases (the terms are interchangeable), politicians and the media like to frame the capital allocation decision in a negative light. They say it props up stock prices so executives can get paid large bonuses without reinvesting into employees or customer service. With terms thrown around like “debt-fueled financial engineering,” it is no wonder normal people misunderstand a perfectly legal process.

Buybacks are not a nefarious tool used by executive teams at the expense of employees and customers. In fact, it is much simpler than that. Share repurchases are similar to dividends, a tool for returning cash to shareholders.

Read on and learn:

• How share repurchases work
• Buybacks place in capital allocation decisions
• What is a good share buyback?
• What is a bad share buyback?

How share repurchases work

Buying back stock is a simple process. With excess cash flow piling up on the balance sheet, management can go to the open market – typically through an investment bank intermediary – and buy its own stock from existing shareholders.

These can be insiders with a 10% position, index funds, or even small-time retail investors. Any shareholder looking to sell on the open market, really.

After buying the stock (this is the only tricky part), management will “retire” the outstanding shares. These shares do not legally exist anymore. A buyback reduces the total number of shares outstanding for a stock.

Why is this valuable? First, for the investors selling their shares, the company has given them cash that they can use out in civilization or reinvest into other stocks.

Second, it increases the ownership of the business for remaining shareholders. To explain this, let’s use an example.

Example of share buyback

For Company X, there are 100 shares outstanding. You own 1 share or 1% of the company (1 divided by 100 is 1%). Then, management repurchases 10 shares from other shareholders, leaving 90 total shares left.

You still own 1 share, which is now 1.11% of the company, up from 1%. While only a small change, a buyback has now given remaining shareholders a higher % of the business ownership, which means you have a larger claim on the future cash flows that come back to you as dividends.

Apple has spent a lot of money on buybacks in the last 10 years. Since 2014, its shares outstanding have declined by around 35%, which has returned hundreds of billions in cash to selling shareholders and increased how much remaining shareholders own of the business. No wonder Warren Buffett likes the stock.

Buybacks, dividends, and capital allocation decisions

Okay, you now understand buybacks. The next step is to relate them to other capital allocation decisions.

A share repurchase is one tactic among many in an executive’s toolbelt for capital allocation decisions. Capital allocation is when an executive team can choose to:

• Reinvest in employee salaries, research, or marketing
• Capital expenditures (i.e. new office buildings or data centers)
• Let cash sit on the balance sheet and earn interest income
• Return capital to shareholders through buybacks and dividends

Typically, smart management teams will go from the top of the income statement (revenue) and move down to the cash flow statement (capital expenditures, buybacks, and dividends).

They will ask, “Do I need to invest in new employees, boost employee salaries/perks, or increase marketing/research expenses?” If so, they will lay out cash to be distributed to these sources in order to keep the business healthy (of course, this is an ideal situation, and not every management team thinks this holistically).

Then, they will ask how much they need to allocate to capital expenditures to maintain or grow infrastructure. Most companies have multi-year capital expenditure plans so executives can manage the money they plan to spend to expand their asset bases.

These first choices can be grouped into “reinvesting capital into the business.” The next group of choices—letting cash sit on the balance sheet, buybacks, and dividends—is what management decides to do with cash after allocating it to employees and company infrastructure.

Set aside the decision to let cash sit in limbo on the balance sheet for a moment. Buybacks and dividends are the two ways corporate executives can return cash to shareholders.

A dividend is a cash payment (typically quarterly) that a management team pays to all shareholders. Buybacks are similar to dividends. They both take cash on the balance sheet and return it to shareholders. Think of a buyback as a huge one-time dividend to the selling shareholder, who gets 100% cash for the market price of the stock.

Many companies will maintain both a dividend and buyback policy to balance returning cash to long-term shareholders while also paying out those who want to exit their positions.

As discussed above, Apple has spent hundreds of billions on share buybacks over the last 10 years. It has also grown its dividend per share at an 8% rate since 2014.

Dividends and buybacks work best when operating in harmony. If a company reduces its shares outstanding, it can increase its dividend per share without needing to increase its nominal dividend payment each year.

Why? Because there are now fewer shares outstanding with claims on these dividend payments. If a company reduces its shares outstanding in half, it can double its dividend per share without having to set out more total cash each year for dividend obligations.

A consistently shrinking share count is a wonderful thing for shareholders. But not all buybacks are created equal.

What is a good share buyback?

Unlike a dividend, management’s execution and timing of a buyback can be crucial to boosting long-term shareholder returns. To understand why this is, we must first understand the concept of an earnings yield.

Earnings yield is the opposite of a price-to-earnings ratio (P/E). You take the annual earnings a stock generates and divide it by the market capitalization. Then, you get a %, which is the earnings yield.

For example, if Apple trades at a P/E of 25, you take one and divide it by 25 to get an earnings yield of 4%.

Why does this matter? When management repurchases stock, the fuel for these buybacks is the company’s earnings. If a stock trades at a high earnings yield, it can reduce its shares outstanding by a large amount each year. If it trades at a low earnings yield, it can only reduce its shares by a small amount.

A management team needs to weigh its earnings yield against the returns it can get from further reinvestment in the business. If the earnings yield is higher than the rate of return on reinvesting for growth, the proper capital allocation decision—all else equal—is to return capital through share repurchases.

Let’s say you are the CEO of a restaurant chain looking to expand store locations.

When you lay out capital for a new store, that store earns a 10% yield on the capital deployed yearly. This is the “cash-on-cash” returns the company gets from a new store location. If the stock trades at an earnings yield of 5% (so below the return it can get on new store openings) the right capital allocation move is to open a new restaurant location. Shareholders will get a better return on new store openings (10% each year) than through share buybacks (5%, assuming all excess earnings are spent on buybacks).

However, if that same company is trading at a 15% earnings yield, management should stop adding new locations and use that capital to repurchase stock instead. Of course, this assumes existing locations have been given proper capital to maintain operations.

A high earnings yield can mean significant reductions in share outstanding. A stock trading at a 15% earnings yield that retires 15% of its shares outstanding for 10 straight years can bring its share count from 1,000 down to 220. That is an approximate 80% reduction in shares outstanding over 10 years.

Mathematically, this means that the remaining shareholders now own 5x of the same business without buying any new shares. This is the beauty of repurchasing shares outstanding at a high earnings yield.

If earnings have remained the same compared to 10 years ago, that means the earnings per share (EPS) have gone up by 5x as well. EPS drives shareholder returns over the long haul.

For example, AutoZone—one of the best stock repurchasers ever—has reduced its shares outstanding by 87% since the beginning of 2000. Along with nominal earnings growth, this has led to an astounding 8,110% growth in EPS over that time frame and huge market outperformance for its common stock.

I think the remaining shareholders are happy with this buyback program.

What is a bad share buyback?

A bad share buyback is the opposite of a good share buyback. We simply need to reverse the above situation.

If a company skips out on necessary investments back into its existing business or decides to repurchase stock at a higher earnings yield than it can obtain through new capital expenditures (or simply sitting in U.S. treasuries, for that matter), management is not intelligently buying back its own stock.

A ton of legacy retailers did this over the last two decades. They failed to invest in e-commerce infrastructure and instead spent money on buybacks, leading to business deterioration and declining share prices. If earnings go to zero, it doesn’t matter how much you spent reducing shares outstanding: remaining shareholders will experience a declining share price.

For example, Kohl’s has spent a cumulative $5.6 billion on share buybacks since 2015. Yet, EPS is down because the company failed to take advantage of the opportunity in e-commerce. Management should have reinvested to modernize its business first, and then it can worry about share buybacks.

Another bad buyback method is repurchasing your stock at a low earnings yield (so a high P/E). Autodesk has only shrunk its share count by 6% since 2015 despite spending tons of money on share repurchases over that period. Why? Because over that period it traded at a low earnings yield, making buybacks an unintelligent capital allocation decision. It would have been better for the company to either return cash through dividends or simply let it sit on the balance sheet and accrue interest income.

Buybacks are misunderstood by many. They are also utilized poorly by many executive teams. But when done intelligently by sharp management teams, they can help increase shareholder returns over the long haul. These are the types of companies you want to add to your portfolio.