Some of the greatest CEOs of all-time used lots of share buybacks to create outstanding returns. In many cases, these share repurchases can be fantastic for investors.
They work as a savings vehicle, and they spurn growth in share value. But they don’t come without their risks.
In this post, we will discuss the pros and cons of share repurchases, in these sections:
- Back to the Basics: Allocating Profits
- Share Repurchases: A Savings Vehicle for Shareholders
- How Buybacks Work with Large Publicly Traded Corporations
- The Riskiness of Share Repurchases
- How the Life Cycle of Businesses Impacts Growth and Buybacks
- Investor Takeaway
To understand why companies repurchase shares, we need to go back to the basics of company profits and the decision to do a buyback itself.
Back to the Basics: Allocating Profits
Remember that a company’s prime directive has been to earn a profit.
Hopefully that’s not profit with no regard to its effects, but in essence, people and institutions start and own businesses to earn a claim to the profits it generates.
When a company earns a profit, those profits can be directed in this way:
- Returned to its owners (shareholders)
- Through Dividends
- And/or share repurchases
- Reinvested back into the company
- Through capital investments or increased hiring
- To buy another company through an acquisition
- Improve the balance sheet
- Pay down debt
- Keep as cash
- And/or buy investments (stocks, bonds, etc.)
Those are a lot of options, and they can greatly affect the future of a company in many aspects—growth and profits, shareholder value and total return, etc.
It’s why great investors like Warren Buffett have said the primary job of a CEO is to allocate capital (make decisions on the company’s profits). These big picture decisions plot the course and direction of the company’s future.
And a common way that CEOs have allocated capital lately has been to repurchase shares.
To understand how that helps a company, we need to know the basics of buybacks.
Share Repurchases: A Savings Vehicle for Shareholders
Going back to Warren Buffett, he recently made a fantastic explanation of how buybacks work by calling them a savings vehicle.
Remember that a company has owners; these are called shareholders.
The number of shares that each owner/shareholder has represents how much of a business each person owns.
It’s not the number of shares that are important, but how many shares someone owns compared to the overall number of shares (shares outstanding).
Let’s say that 5 people equally owned a company; each person owned 20% of the company.
If there are 100 shares outstanding, each owner would have 20 shares.
In the same token, if there are 1,000 shares outstanding, each owner would have 200 shares.
It’s not the total number of shares that a person has that is important, but instead how many shares a person has compared to overall shares outstanding. This is critical to understanding the nuts and bolts of share repurchases in large corporations.
Now let’s say that 1 person of the 5 wants to be bought out of the company.
They basically want a lump sum payment for their ownership, for any reason at all. If the company is worth $100 million, for example, then the person with 20% ownership would be paid out $20 million to give up their 20% ownership stake.
In order to do this, the other co-owners need to come up with cash to buyout the leaving partner.
This can happen a number of ways, but if they have the cash inside the business (through profits), then they can take that cash to buyout the partner.
Now that one co-owner is gone, each of the remaining 4 now each own 25% of the business instead of 20%.
The nuts and bolts of this would be performed through a share repurchase—by the company buying back the ownership stake of the leaving partner (his/her 20 shares) and retiring the shares, the company now has 80 shares outstanding instead of 100.
That means that the 20 shares that each co-owner has now represents 25% ownership of the company instead of 20% (20/80 = 25%). That means a 25% claim to the company’s profits instead of a 20%.
By the company using profits to reduce shares outstanding (which is what a stock buyback is), the company has made each share of stock more valuable, because each share now represents a higher ownership stake.
Let’s say that the same process continued to happen over the years.
The owners who keep their shares will continue to see their ownership stake increase, even if the company’s profits stay the same.
In other words, even if the company itself doesn’t grow, its shareholders see growth through a higher ownership claim of those profits as more owners get bought out and the company buys back more shares.
The same thing happens in the stock market but on a much grander scale.
How Buybacks Work with Large Publicly Traded Corporations
Companies can have hundreds or thousands or millions of owners, and as stocks trade you have co-owners cashing out their ownership stake for a lump sum. That is what is happening when an investor sells a stock.
There’s always a buyer on the other side, so an investor could simply be transferring ownership to another investor—or if it’s the company who’s doing the buying (through a share repurchase), they could retire the shares to reduce shares outstanding.
The scope to how much each shareholder owns a claim to a company’s profits is represented through EPS, or Earnings Per Share.
The EPS for a stock can grow through two ways:
- Higher Earnings
- Lower shares outstanding
Really quick—earnings per share is calculated very simply:
EPS = Earnings / Shares Outstanding
Remember that with a share repurchase, a company is reducing shares outstanding to increase the ownership stake of the remaining owners. This is represented through EPS by reducing the denominator of the formula.
So the EPS can grow even if the company earns the same amount of profits each year, simply by reinvesting those profits into stock buybacks.
This increases shareholder value, aka the price of each share of stock.
The Riskiness of Share Repurchases
You might wonder why all companies don’t just repurchase shares. It sounds like an obvious way to grow value for shareholders.
Well the problem with share repurchases is that sometimes there are better ways to spend that money.
Take a company like Amazon as an example.
For a while, Amazon was a growth company and didn’t earn many profits. However as they got to scale, they finally turned a profit, and decided to reinvest in the company through large capital investments.
Some of the projects they invested in failed and some succeeded—but they really hit a home run with AWS.
AWS, or Amazon Web Services, basically hosts internet processing and storage for many of the websites you probably use today.
AWS is a huge cash generator for Amazon, but it was only possible because they reinvested their profits into capital investments instead of share buybacks.
The risk of share buybacks is that a company could reduce future earning power by not reinvesting into enough growth projects, and watch the company’s success fade away as competitors come up with better ways to serve customers.
Investors and managers (CEOs) have a tough call to make—when are share repurchases smart and when are they foolish?
How the Life Cycle of Businesses Impacts Growth and Buybacks
One last piece to this puzzle is to understand that, like human beings, every company has a limited shelf life.
The average life expectancy of companies has been steadily dropping especially with the advent of the internet, and that trend doesn’t look to be reversing any time soon.
In a normal capitalist market, this is a good thing for consumers.
Scrappy startups find cheaper and better ways to serve customers, and as they grow from new competitive advantages, you have old companies with obsolete products and services who fade away.
It’s the beautiful cycle of life in business which propels innovation and improves our quality of life.
I’ll be the first to say that you would not even have the luxury of reading this post without it.
Many, many companies see growth (of revenues and profits) as the answer to the unavoidable life cycle problem.
And so oftentimes, companies will reinvest their profits to endlessly chase growth, until those investments prove to be wasted uses of capital. In other words, it destroys shareholder value.
When Growth Is Unsustainable
For every Microsoft and Amazon who delayed the inevitable plateau of business success by finding homerun investments in new, high growth industries like the cloud, there are dozens of businesses who made imprudent investments and took heavy losses on them down the road.
The problem with the business life cycle and company growth is that eventually high levels of growth have to stall, otherwise a company will become bigger than the world economy (or become the economy).
So those profits have to go somewhere, and oftentimes they are wasted on expensive acquisitions and fruitless investments which destroy value and cause a big company to get big and bloated.
Smart leaders of big businesses should know this and instead of trying to get big, should prudently repurchase shares in order to continually increase shareholder value.
Examples of leaders who did this are plentiful in the great book The Outsiders: Eight Unconventional CEOs and Their Radically Rational Blueprint for Success by William Thorndike.
The CEOs profiled in this book earned returned compounding for shareholders that was way above and beyond the stock market average by prudently buying back shares and limiting wasteful investments.
But at the end of the day, it goes back to the life cycle problem again.
Eventually, every business’s cash cow starts to decay, and so companies like Teledyne, the Washington Post, Capital Cities, and the others profiled in the book…
The riskiness of share repurchases comes with the fact that it works for as long as the company’s cash cow is alive and kicking.
Once this is no longer the case, you can’t turn back the clock.
Cash that could’ve been used to reinvest in new projects was spent on buybacks, and once the core business starts to decay, so does the effectiveness of those previous buybacks.
But remember that investments in new revenue and profit streams is not the panacea to this problem.
Being ultra conservative and keeping stacks of cash in the coffers doesn’t help much if the company’s core operations starts burning capital and fading into obsolescence.
Managers have a tough dichotomy to solve between the opportunities of shareholder growth today with share repurchases, and the opportunity cost missed for tomorrow.
At the end of the day there’s no right answer to this, and so for every company it’s going to look different.
Which is why I hope you really internalize each of these core parts of share repurchases and their impacts to the future of companies and shareholders.
All companies have to deal with the inevitable life cycle—and no amounts of future reinvestments can thwart this problem forever, though some companies have been able to stand the test of time even over 100 years.
But consider another great insight from Buffett in his latest shareholder meeting—the top 20 stocks of today are completely different from the top 20 in 1989.
Not a single company is on both lists.
The next logical question after why do companies repurchase shares is, “Should this company repurchase its shares?”, and that will depend on smart decision making, aka capital allocation.
Companies can vary greatly with how long they can stay profitable in the life cycle.
A company like See’s Candies has continued to thrive even without greatly increasing the number of stores, because it is a cash cow.
There are times when growth actually destroys value for a company, and it’s the smart CEOs who can identify that point and allocate to share buybacks and dividends who can compound shareholder value for many, many years.
Hopefully after reading this post you have some ideas for identifying these kinds of situations, and properly allocating your own capital into those which show the best ability to grow shareholder value either through business growth or total shareholder return.
Because no company lives forever, and because they can’t grow forever into the sky, companies must eventually sacrifice growth of the business to continue growing shareholder value.
But by using something like share buybacks to increase the value per share, they can still serve as fantastic investments and generate great returns for much longer than most companies can.
And that’s why companies repurchase shares, and why it’s a great thing for investors when done at the right times.