In today’s market, stock repurchases are the choice that most public companies use to return value to their shareholders. Investing giants such as Warren Buffett and Jamie Dimon applaud these efforts.
Warren has commented multiple times in his Berkshire Hathaway Letters to Shareholders on his fondness for stock repurchases, also known as buybacks.
Buffett’s thoughts from his latest letter, 2019:
- “Repurchases will benefit both those shareholders leaving the company and those who stay.”
- “When stock can be bought below a business’s value, it probably is its best use of cash.”
As for Jamie Dimon, CEO of JP Morgan, who has bought back 20% of their shares over the five years to the tune of $55 billion, per it’s 2018 annual report.
Dimon’s thoughts about stock repurchases:
- “We believe stock buybacks are an essential part of proper capital allocation.”
- “Buybacks…are an important tool that businesses must have to reallocate excess capital.”
- “Buybacks should not be done at the expense of properly investing in our company.”
Stock repurchases have been the main driver of shareholder value over the last bull market certainly and will continue long into the future. According to the Wall Street Journal, total spending on stock (or share) repurchases projects to reach $940 million in 2019.
Although share repurchases have been all the rage in capital allocation among public companies, there has been some opposition to this practice.
The opposition comes mostly from the Democratic side of the aisle, leading candidates for the upcoming Presidential elections, Bernie Sanders and Elizabeth Warren have been highly critical of these practices. More on this topic to come.
In today’s post will discuss the following topics:
- What are stock repurchases?
- How do they benefit shareholders?
- How can we see the effects from a financial statement point of view?
- Are there any risks to share repurchases?
What Are Stock Repurchases or Buybacks?
There are three main ways that companies can return value to its shareholders.
- Share price appreciation
- Dividends
- Share repurchases
Share prices rising is one of the most common ways that a company can reward us for investing our money with them. Dividends over the years have proven to be extremely valuable to shareholders as well. With the ability to DRIP your dividends and the power of compounding by your side, these two more traditional methods of shareholder value have long dominated the stock market.
But more recently, there has been a turn towards share repurchases as a source of capital allocation or a way to return value.
So what is a stock repurchase, also known as a share buyback?
A share repurchase is what it sounds like; it is the process of a company buying its shares from the markets with its cash. The use of share repurchases is a method of re-investing in itself.
Once repurchased, the shares are absorbed back into the company, which reduces the shares available in the market. The benefit to shareholders comes from the share reduction, which increases the value of each share the shareholders own.
How do Stock Repurchases Work?
Unfortunately, they can’t go to their broker and buy the shares there; it is a bit more complicated than that. There are two ways that companies can execute stock repurchases.
According to Investopedia:
- “Tender Offer: The company shareholders receive a tender offer that requests them to submit, or tender, a portion or all of their shares within a certain time frame. The offer will state the number of shares the company wants to repurchase and a price range for the shares. Investors who accept the offer will state how many shares they want to tender along with the price they are willing to accept. Once the company has received all of the offers, it will find the right mix to buy the shares at the lowest cost.”
- “Open Market: A company can also buy its shares on the open market at the market price. It is often the case, however, that the announcement of a buyback causes the share price to shoot up because the market perceives it as a positive signal.”
It is important to note that once word of a tender offer or the announcement on the open market of an intention to buy shares will typically cause the company’s share price to rise.
Each company has to get approval from the board of directors to initiate a share repurchase program. For example, Brighthouse Financial (BHF) recently announced approval to repurchase up to $500 million of their common stock; this was in addition to the $600 million they had previously approved. Through January 2020, Brighthouse Financial has repurchased approximately $570 million of its common stock.
The company announced that it was part of their plan to use share repurchases to return over $1.5 billion to its shareholders.
Why Are Stock Repurchases Done?
The most common reason for share repurchases is that management feels this is the best way to allocate capital at the current time. After all, the number one job of a companies management is to squeeze out the most value for its shareholders.
Buybacks typically increase value for shareholders, therefore why they continue to be in use.
Why would management feel that repurchases are the best choice? One reason is management feels that the market has undervalued the company. In other words, they feel the price is less than they feel it is worth.
Many times, the market beats up certain companies or sectors, such as financials. The circumstances around the negative feelings in the market may be valid, such as negative earnings, a scandal, or a downturn in the financials of a company.
But, there are times when the downturn is for no real reason that can be determined.
When a company declares that it is going to repurchase its shares, this can be a signal to the market that management believes in the company and that they feel the market has gone too far in discounting the share prices. For example, with the above example of Brighthouse Financial, the announcement of the repurchase program caused a rise in share prices of over 2%.
Another not so positive reason for initiating a repurchase program would be to improve the financial metrics of the company. For example, a reduction in shares outstanding can improve the earnings per share of any company. With the reduction of shares available, even with flat earnings, a company can report a growth in earnings per share.
Is this legal? Yes, it is, but the bigger question would be the motivation for the repurchase program as opposed to reinvesting in the assets of the company or a dividend increase.
With Wall Streets’ obsession with earnings and growth in the earnings, every quarter, each company on Wall Street is under the gun to report a growth in their earnings. They run the risk of its share price falling if there is no growth in earnings, and most company’s management has their compensation tied to the company’s stock.
And if the price goes down, they make less money, if the price rises they make more money.
The compensation of management is an important item to be aware of when considering investing in any company; we need to understand their motives for allocating any capital of our company.
Let’s look at how share repurchases can impact the financial ratios of a company.
How Stock Repurchases Impact Finacial Ratios
When repurchasing shares, this reduces the number of shares available in the market. Once the company owns their shares, they have several options of what to do with them.
First, they can cancel them, or they can keep them as treasury shares, both of which reduce the number of shares outstanding.
Besides earnings per share or EPS, other financial metrics that are affected as well are return on assets and return on equity. Return on assets increases because when using cash to repurchase the shares, it reduces the assets on the balance sheet. Likewise, return on equity increases because there is less equity on the balance sheet as well.
All of these metrics increasing is viewed as a positive sign in the market and can give the stock price of any company a little extra juice.
Let’s take a look at the financials of a real company so we can see this in action.
The company I would like to use first for our deeper look into stock repurchases is Apple (AAPL). I am going to use the latest quarterly report (10q) for our deep dive. The date of the report is 12-28-19, we can use the annual (10k) as well, but I thought I would use a more recent financial report to illustrate.
The first item we will look for is some notification of any share repurchases that might be authorized.
In the notes section of the 10q, there is a notification of share repurchases as part of the shareholders’ equity.
It states that Apple repurchased 70.4 million shares of its common stock for $20 billion, as well as 30.4 million shares under an accelerated repurchase agreement. It also notes that the shares may be purchased under a privately negotiated or open market transactions.
We can see from the above statement the amount that was authorized as well as the method that the repurchases can occur.
Let’s track the money as it goes through the financial statements, as well as how they affect the financial metrics.
The first place we will look at is the balance sheet, which will be a two-step process.
Let’s look at the retained earnings on the balance sheet.
We can see from the balance sheet that the retained earnings for Apple are $43,977, now we are going to uncover what makes up the retained earnings.
And there we can see the $20 billion of common stock purchases that were authorized.
Now that we can see that share repurchases were authorized to let’s look at some of the effects these repurchases can have on the financial metrics.
Before we do that, let’s look at the income statement.
Notice that the earnings per share improved from the previous year’s 10q and that you can see the decrease in shares, as was discussed in the repurchase program. If we want to see the decrease by each quarter of share repurchases, we would look at the previous quarters 10q and subtract the resulting difference in shares.
We can see from the income statement that there is an increase in earnings per share by dividing the net earnings by the diluted shares available.
EPS = 22,236,000 / 4,454,604
EPS = $4.99
If you take a bigger look at Apple, you can see that their net sales increased year over year, as well as their net earnings, plus you add in the reduction in shares, and you get a boost in earnings, which Wall Street loves.
In addition to the increase of earnings per share, we also get a reduction in price to earnings. A reduction in price to earnings is a good sign as well, makes the company more attractive with a lower price to earnings.
Price to Earnings = Quarter End price / TTM EPS
Price to Earnings = $293.65 / $12.66
Price to Earnings = 23.20
Also, we see an increase in the return on assets; with the reduction in cash to repurchase the shares, there is a reduction in assets.
If you look at the return on assets of Apple over the last five years, it has seen a steady increase, partially on the strength of Apple’s performance, but also with the continual repurchasing of shares.
Return on Assets = Net income Q4 2019 / ( Total Assets Q3 2019 + Total Assets Q4 2019)/2
Return on Assets = 88944 / ( 338516 + 340618)) / 2)
Return on Assets = 26.19%
The final metric we will talk about is the increase in return on equity, with the reduction in equity from the repurchasing of shares, we get an increase in return on equity — also, a very attractive metric to entice more purchases of Apple stock.
Return on Equity = Net income Q4 2019 / ( Total equity Q3 2019 + Total equity Q4 2019)) / 2)
Return on Equity = 88944 / ( 90488 + 89531))/2
Return on Equity = 98.82%
Now the return on equity for Apple is ridiculous, but you can see from one quarter to the next there is a reduction in the equity, but the net income remains the same.
The examples apply for both the ROA and ROE, and I hope it helps illustrate the effect that share repurchases can have on the financials of a company.
Ok, we have discussed the financials. Now let’s look at a few more benefits of share repurchases, as well as some possible negative benefits.
Pros and Cons of Stock Repurchases
One of the pros that we have not discussed so far is that it allows a company to benefit from the undervaluation of shares. If the company is trading below their intrinsic value, and they conduct stock repurchases, this will unlock tremendous value for the shareholders as the stock price eventually rises toward fair value.
Another benefit of share repurchases is the tax benefit you receive from the repurchases. When a company repurchases shares, those taxes are lower capital gains, as opposed to dividends, which are taxed as ordinary income when the dividends are received.
Staying with the dividend theme, there are additional benefits related to dividends. Paying regular dividends is important to any company paying them, and the dividend must be in proportion to its free cash flow, this can’t be an ever-increasing and constant, it will naturally fluctuate.
The dividend is preferred to be a constant dividend. Tying it to the ebbs and flows of the free cash flow, it would naturally rise with increases in cash flow and decrease with downturns in free cash flow. No company or shareholder would accept this situation; it is far better to be constant and grow steadily.
How does this relate, you ask? Well, companies prefer to keep the dividend payouts steady, and hopefully growing, at a reasonable rate. But when there is a huge increase in the free cash flow of a company, it is far more preferable to offer a share repurchase program as a means of returning more shareholder value.
Using excess cash to repay shareholders with repurchases is a better option as opposed to large increases in the dividends, plus for the shareholders, the tax benefit matches as well.
With the increase in equity compensation for management, or the dilution of equity with the exercising of options to liquidate shares, to offset this, companies can choose to repurchase shares from the market.
Cons
Ok, now let’s explore a few of the possible negative benefits of share repurchases.
First up is an obvious one. If repurchases are done to prop up a company to make it appear more successful than it is can be extremely harmful.
For example, say the revenue is falling or flat, but the company buys back its shares, which in turn makes the net income or bottom line look better than it is by offering a rising EPS compared to a declining top line or bottom line.
Or if there was another option to utilize the cash to advance the company better, say in purchasing additional assets to grow the revenue, or possibly acquiring another company that could add additional long-term value.
Another example of poor use of capital is the repurchasing of shares when the intrinsic value of the company is such that they are overpaying for the shares, and there is little to no gain for the shareholders.
All these examples of management using the tool of share repurchases to increase their value for their gain. One of the troubles concerning management compensation, tying itself to stock options, is that it can create the desire to enrich themselves as opposed to the shareholders.
The final downside is the potential political backlash from repurchases in today’s political environment that has been a hyper-focus on CEO compensation and corporate actions. Many of the Democratic challengers for the President have challenged the decisions to repurchase shares. Bernie Sanders and Elizabeth Warren have been extremely critical of these decisions, feeling that the money would benefit the employees more by increasing employee compensation first, before compensating the shareholders.
Final Thoughts
Stock repurchases have benefits and drawbacks; like most things in finance, there is no finite answer.
We have seen that buybacks reduce the number of shares outstanding and the company’s total assets. Both of which can affect the company and shareholders in a multiple of ways.
First, the reduction in shares helps boost the earnings per share, price to earnings, return on equity, and return on assets. The increase in all the financial metrics can help give the share price a nice boost, especially with Wall Street putting so much emphasis on earnings, and growth in earnings.
The stock market will always reward share repurchases by increasing the shareholder’s value with an increase in the share price. However, the question investors need to ask, are the buybacks merely a way to prop up ratios and provide short-term relief to a struggling company.
Or are the repurchases done for another purpose, say to help increase management pay or give a boost to the share price before shares are redeemed.
These are all ideas that must be kept in mind when considering the reasons for any share repurchases.
As always, thank you so much for taking the time to read this post. I hope you found some value from it and that there are items that you can use on your investing journey.
If you have any questions or if I can be of any further assistance, please let me know.
Take care,
Dave
