Stock Buybacks: Are They Good Or Bad?

Last update on Nov. 3, 2014.

IBM

 

On October 28th, IBM announced that they planned on buying back more of their stocks. The announcement was predictably met with howls of criticism from pundits who have labeled the buybacks as "stock-rigging".

But what are buybacks anyway, and are they good or bad? In this article, I'll explain buybacks using both a simple example and the real life example found in IBM. By the way, please note that I currently own IBM stocks.

 

Buybacks And Its Effects

As the name implies, a stock buyback (also called stock repurchases) consists of the company buying its own shares in the market. Buybacks have greater consequences than a normal trade where two outside investors trade shares, because once a company buys its own shares, those shares are cancelled out.

For example, let's say we have company ABC that has 5 million shares outstanding. If one investor trades his/her shares to another, the number of shares outstanding remains the same at 5 million. However, if ABC buys 500,000 of its own shares, then the number of shares outstanding goes down to 4.5 million.

Buybacks have a way of boosting earnings per share of a company by virtue of shrinking the size of the overall "pie". Let's say for instance, that ABC earned $10 million a year. With 5 million shares, that means each share theoretically lays claim to $2 a year in earnings. If ABC buys back 500,000 shares and if earnings remain the same, each share would lay claim to $10 million / 4.5 million = $2.22 a year in earnings, an 11% increase.

Through share buybacks, a company can increase its earnings per share for its remaining shareholders without even having to increase overall profits. This increase in earnings per share is 100% legitimate.

The degree to which buybacks boost earnings depend on a company's valuation. We saw how buying back ABC's shares at $20/share served to increase earnings per share by roughly 11%. But what if ABC's shares are priced at $40/share?

In this case, ABC as a whole would be valued at $200 million. If ABC uses all $10 million of its earnings in the year to buy back stock, ABC would only be able to buy 250,000 shares. In this scenario, the remaining shareholders will experience an earnings boost from $2/share to $2.11/share.

This example illustrates a main point. Stock buybacks are more effective when the company is cheaper, and vice versa. That's because there's another way to view stock buybacks:

When a company buys its own stocks, that company is investing in their own stock.

If holding stocks in the company would have generated 10% in returns, then by buying back stock, the remaining shareholders will see increases in earnings almost as if the company had invested in a business opportunity that generated 10%/year in returns. If holding the company would have generated 5%/year instead, the benefit to remaining shareholders would go down to 5%/year as well.

Therefore, the better the company is as an investment, the more effective stock buybacks are for the remaining shareholders.

 

When Buybacks Make Sense

Share buybacks don't come without costs. Every dollar spent buying back shares is a dollar not spent on dividends or on growing the business. Therefore, whether share buybacks make sense or not depends on the effectiveness these alternative choices for the company.

Let's first consider the option of investing in the business. Let's say that ABC is a retailer. Judging by historical data, ABC might conclude that spending $10 million on a few stores will generate an extra $1 million a year in earnings forever (i.e. 10% rate of return on investment). If they follow through with this plan, ABC will go from earning $10 million a year to $11 million a year, and this would boost the earnings per share of its shareholders to $11 million / 5 million = $2.2 per share.

On the other hand, let's say that ABC thinks it will only earn an extra $500,000 a year forever if they spend $10 million on the stores (5% rate of return on investments). In this case, ABC's earnings will go up to $10.5 million, and shareholders will earn $2.1 per share.

Whether a company should buy back stocks or invest in the business depends on which action would lead to higher earnings per share.

In the above example, ABC might be valued cheaply such that buying back shares would increase earnings per share to $2.22 a share, whereas investing in the business would increase earnings to $2.1 per share. In this instance, ABC should buy back shares. On the other hand, if ABC is valued richly such that buying back shares would increase earnings per share to only $2.11, and if investing in the business would increase earnings per share to $2.2, then ABC should invest in the business.

Lastly, there's the option of paying dividends instead of buying back shares and investing in the business. I've already written an article on this subject so I'll just reiterate the conclusion. Paying dividends only make sense if the company lacks decent investment or buyback opportunities.

 

The Case Of IBM

In summary, companies should buy back stock if doing so would benefit its shareholders more than if they invested in the business or paid dividends instead. Companies shouldn't buy back stock if one of the other options would benefit shareholders more. In light of this, let's now consider IBM's recent buyback announcement. 

At current prices, IBM as a whole is valued at roughly $160 billion, and the company has earned roughly $16 billion a year over the past 3 years.  If we assume that IBM will experience zero growth and keep earning $16 billion a year, then each dollar spent on buying back shares would be like investing in a project that generates a 10%/year rate of return. If we assume positive growth in earnings, then buying back shares would be like investing in a project that returns above 10%/year.

On the other hand, IBM could instead invest the money back into their business, and this is the crux of the debate. IF IBM has the opportunity to deploy their cash and make substantial returns, they should do so. On the other hand, if they don't have such opportunities, they should buy back stock instead.

Investors who complain about IBM's buybacks often assume that IBM has good opportunities to invest in their business. But I don't think it's that simple.

Let's think about what investing in the business actually looks like. In IBM's case, it would likely entail hiring some PhDs, sticking them in a lab and telling them to come up with something.

While IBM spends billions of dollars a year already doing just that, there's a limit to what you can do. After all, you can't just hire people and give them zero direction. The company first needs to determine what problems their customers need solving, and then hire people with the right skill set to solve that problem. In other words, you can't just pour money into research and expect to receive good returns out of it.

Instead of pouring cash into dubious projects, IBM's management has opted to buy back their own stock instead, and realize a decent (10+%/year by my estimate) rate of return. This is part of the reason why Warren Buffett likes IBM, and it's part of the reason why I own it as well.

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