EDUCATION PIECE by Market Index.UNDERSTANDING SHARE BUYBACKS...

EDUCATION PIECE by Market Index.

UNDERSTANDING SHARE BUYBACKS

Share buybacks (sometimes called stock buybacks) occur when a company buys back its own shares from the public market. “Since 1997, share repurchases have surpassed cash dividends and become the dominant form of corporate payout in the U.S.,” notes S&P Global. The idea is to reduce the number of shares in circulation to increase the value of each remaining share. For example: Let’s say that XYZ company has 1 billion shares outstanding, and earns $5bn in annual profits. This gives the stock an earnings per share (EPS) of $5. Now, let’s imagine the company buys back 100m of its own shares: This reduces the outstanding shares to 900m. Assuming profits remain level, the EPS goes up to $5.56 (i.e. $5bn / 900m shares). Why perform a buyback? Buybacks can make a stock more attractive to investors by increasing the company’s EPS. Buybacks also increase the concentration of a company's ownership among existing shareholders. They can also signal that the company is confident in their future growth prospects (otherwise the company wouldn’t be buying their own shares). In the absence of compelling growth opportunities or debt reduction, share buybacks can be an attractive and easy option for companies with surplus cash. However, there’s more to the story: Companies know that some investors look at share buybacks as a sign that a stock is undervalued. This means they can sometimes be used as a tool to manipulate public perception – rather than a clear sign of future growth prospects. Companies may buy back shares for a variety of reasons, not just because they believe their stock is undervalued. They might be trying to: Boost EPS to meet internal financial targets. Artificially boost the price of their stock, without delivering improved value. Offset the dilutive effects of stock-based compensation (this is where employees and executives receive shares or stock options as part of their compensation). Also worth noting: as markets have become increasingly flooded with liquidity (from governments pumping cash into the system in the wake of the GFC), the volume of buybacks has increased substantially. Just take a look at this chart:

How do the numbers look? During the ten years after the GFC, Bruce Dravis (past chair of the American Bar Association's corporate governance committee) studied US$1.23 trillion in Fortune 100 company buybacks. He found that: 36.9% of buybacks were done to offset equity compensation dilution. 63.1% of buybacks were so-called ‘pure play’ buybacks that aimed to reduced share count without motivation to offset equity compensation. When’s the best time to do a buyback? At Berkshire Hathaway’s 2004 annual meeting, Warren Buffet shared a simple rule of thumb for buybacks: “When stock can be bought below a business’s value it is probably the best use of cash.” Of course, that’s easier said than done. “The tough part is coming up with the intrinsic value. There is a lot more to intrinsic value than P/E,” he said in 2016. He’s also said that there is no single metric that can justify or reject a buyback; instead, a combination of factors must be considered. Buybacks can also raise a possible red flag. If a company is doing a buyback, it might be because they can’t think of a good acquisition, asset purchase, or other capital-intensive business expense to deploy their cash towards instead. Apple’s massive buybacks: Berkshire Hathaway’s largest investment is Apple - which has been prolific with share buybacks. In 2022, Apple bought back around US$90bn of its own shares. In 2021, they bought back about US$85.5bn. Over the past decade, they’ve spent over US$550bn on buybacks - more than any other US company.