In my last post I discussed dividends which are one method which company management can use to return value to shareholders. The other main method is what is known as stock buybacks. The official term is share repurchases, but I’ll use buybacks as that is the term most commonly used.
I’ll first define stock buybacks, and then provide a quick example of how they work.
What are stock buybacks?
Stock buybacks occur when a company uses cash to purchase it’s own stock from current shareholders. This results in a few immediate effects. Reduction in the number of shares outstanding, reduction in the cash held by the company, change in the value of the company, and most of the time a change in the per share value of the company.
Prior to a stock buyback, a company has the following characteristics:
- $1,000,000 in cash, $9,000,000 in other assets and no debt. This means the company has a value of $10,000,000.
- 100,000 shares outstanding, valued at $100/share
- You own 1,000 shares of the company.
The company decides to use all $1,000,000 of its cash to buy back shares of it’s stock at $100/share. Assuming they are able to find sellers for the full 10,000 shares, the company will reduce it’s outstanding shares by 10,000. This will also reduce the cash held by the company and reduce the value of the company.
After the stock buyback, the company has the following characteristics:
- $0 in cash, $9,000,000 in other assets and no debt. This means the company has a value of $9,000,000.
- 90,000 shares outstanding, valued at $100/share.
- You own 1,000 shares of the company.
In this example, someone who didn’t sell their shares to the company doesn’t seem to have gained much from this action. Their shares are still worth $100/share and they haven’t received any cash or additional shares. However, they have increased their ownership in the company.
What is the effect on you?
- Both before and after, the value of your holdings is $100,000.
- Before the buyback, you owned 1.00% of the company.
- After the buyback, you owned 1.11% of the company.
The buyback increased your ownership in the company by 11%. Although the buyback didn’t provide you with an immediate gain in portfolio value, it did change your ownership % in the company. This increase will mean that any future earnings from the company are due to you at a larger percentage than they were before.
The fact that your portfolio value didn’t change directly due to the buyback is exactly the same way that dividends work. Assuming both dividends and buybacks are taxed in the same way, there should be no preference between the two.¹ Both are methods that return cash to shareholders. The difference is that dividends are paid to all shareholders without any requirement of selling their shares, while share buybacks use cash to pay fewer shareholders that have to sell their shares to get the cash.
In this example, the per share value of the company didn’t change with the buy back. The reason is that the market price and the book value were the same. If the market price was different than the book value, then the per share value of the company would change as well. If the market price of the company is above the book value, then the per share value of the company will go down. However, if the market price of the company is below book value, then the per share value of the company will increase.This is a very important point to remember. Most company managers don’t realize this and end up destroying shareholder value by performing buybacks at the wrong time. Be aware of this next time you see a company buyback announced.
Stock buybacks are just one way of returning value to shareholders. The other most common method is dividend payments. When a company repurchases their own shares, the number of shares outstanding decreases. The percentage ownership for continuing shareholders will increase, but the overall value of the company will go down by the amount of cash spent to repurchase the shares. Unlike with dividends, it is important to consider the market price vs the book value when choosing to perform a stock buyback.
What do you think of stock buybacks? Would you want companies that you own to perform them? Leave your thoughts in the comments below.
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¹Taxes will drastically affect the relative performance of dividends and share buybacks. In the United States, dividends are taxed while share buybacks are not. That is why, at the time of this writing, many companies are relying more and more on share buybacks to return cash to shareholders instead of dividends.