| The
Importance of Share Buybacks |
Published: May 16, 2006
Corporate managers are charged
with a straightforward task: to enhance shareholder value. In many
cases, creating value means introducing a new product or taking steps to
cut costs and overhead -- complex steps that can take years to
implement. But there's another more direct way to boost shareholder
value -- a method that's been used consistently by America's most
successful companies for decades. Investors who understand this secret
value-generation formula can quickly and easily identify companies with
the capability to generate impressive long-term returns.
And who better to explain value
creation than legendary investor Warren Buffett? Every year Buffett
writes a lengthy annual letter to investors in his primary holding
company -- Berkshire Hathaway (BRKa). These letters detail Buffett's
outlook on various stocks, the market, and the economy in general.
However, investors are often most interested in Buffett's investing
wisdom; Buffett occasionally reveals a timeless morsel of investing
advice that offers a glimpse into the methodology behind his stellar
long-term track record.
In his 1984 annual letter,
Buffett revealed yet another bit of wisdom. Specifically Buffett wrote
that companies with outstanding businesses, solid financials and an
undervalued stock could perform "no alternative action that could
benefit shareholders as much as share repurchases." In other words,
Buffett believes that companies with undervalued stock prices can return
significant value to shareholders by simply buying back their own stock.
In fact, many of Buffett's most
successful investments are famous for doing just that. Coca-Cola (KO),
for example, instituted its share repurchase program in 1984, and since
that time it has repurchased more than 900 million shares. Given that
Coke had just over 3 billion shares outstanding at the beginning of
1984, the company has repurchased nearly one-third of its outstanding
share count over a 20-year period. And then there's American Express
(AXP), another famous Buffett holding that has consistently been
repurchasing its shares for more than a decade.
Buybacks and Value
So, why do these great companies institute share buybacks? The fact is
that repurchases are a direct way of returning cash to shareholders;
share buybacks directly boost every shareholder's stake in the company.
Recall that shares represent ownership in a company, as well as a share
in the profits the firm generates over time. Each share represents an
equal stake in those profits.
When a company repurchases its
stock, the shares purchased are either canceled or held as so-called
"treasury stock" -- in either case, the shares are no longer
freely traded or counted as outstanding shares. (Shares held as treasury
stock can be re-issued at any time. By contrast, if the shares are
canceled, then they cease to exist permanently.)
The action of buying back stock
has no effect on a company's total profits and cash flow. The effect is
not on total earnings, but instead shows up on its earnings per share
(EPS) -- total earnings divided by total shares outstanding. As a firm
repurchases its shares, its existing shareholders own a larger and
larger slice of the firm's earnings pie, thereby boosting EPS.
The Power of Share
Repurchase Plans -- An Example
The
best way to illustrate the power of buybacks is with an example.
Consider the case of Coca-Cola from 1984 through 2005, and check out my
chart.
I calculated Coke's earnings
per share (EPS) on a split-adjusted basis going back to 1983. The blue
portion of each bar represents earnings per share based on the 1983
share count of more than 3.2 billion shares. Meanwhile, the red portion
of each bar represents the cumulative effect of the company's repurchase
of 900 million shares. It's clear that as Coke gradually repurchased
more shares through the late 1980s and into the 1990s, the effect on EPS
became more dramatic. Last year, for example, Coke earned more than
$2.05 per share. However, had the company not repurchased shares
aggressively for more than 20 years, those earnings would have been only
$1.49, some 28% less.
Another
way to look at this is that Coke's EPS increased from roughly $0.17 in
1983 to more than $2.05 in 2005. That's equivalent to an annualized
growth rate of +12% over this entire 22-year period. But if we exclude
the effect of share repurchases over this period, then earnings would
have grown to only $1.49 by 2005 -- equivalent to an annualized growth
rate of just +10.4%. In other words, share repurchases have boosted
Coke's growth rate by more than 1.6 percentage points per year over this
long period of time. And undoubtedly, as you can see in my chart, the
company's targeted value-generation plan has helped the stock to
massively outperform the S&P 500 over the past 22 years.
Of course, share repurchase
programs do far more than just directly boost shareholders' stake in a
firm. Consistent repurchases of stock imply other positives about a
company's fundamentals and management's confidence in a firm's
prospects. For example, if a company is buying back stock without taking
on debt to fund those purchases, then it suggests that the firm
generates a good deal of free cash flow. Coke, for example, generated
more than $5.7 billion in free cash flow in 2005. It then used a good
portion of this cash to fund its stock repurchases.
Taking things a step further,
many investors also scrutinize insider trading data to discern if senior
management is buying stock -- several academic studies confirm that
companies with strong insider buying have tended to outperform over the
long haul. Similarly, massive share repurchases can signal management's
confidence in the value of the stock. By deploying cash to buy back
stock rather than expand into new markets or pay a larger dividend,
management is often signaling that it believes its stock is
fundamentally undervalued.
Good investing!
-- Paul Tracy
Editor
StreetAuthority
Market Advisor
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Paul Tracy
founded StreetAuthority and became Chief Investment Strategist in 2001. Prior to
that he spent several years as Managing Editor at a multi-million dollar
financial publishing firm with over 150,000 subscribers. In addition to
his role as managing editor and lead financial writer, he was also
responsible for equity research and managing a team of seasoned
professional financial writers, researchers and market commentators.
Paul's previous experience
includes a position at Robert W. Baird & Co.'s full-service
brokerage operations as well as economic research work on a Money and
Banking project funded by the National Bureau of Economic Research. He
has also spent time doing outside consulting and research for the
University of Virginia, has appeared as a guest expert on several
prominent financial radio shows, and has been a featured speaker at
various investment conferences across the U.S.
Paul graduated with a B.S.
in Finance and Management from the McIntire School of Commerce at the
University of Virginia.
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