Understanding Stock Buybacks

Stock buybacks are when companies repurchase their own shares. This common practice affects earnings per share, share price, and shareholder value. [DEFINITION] Stock Buyback (Share Repurchase): When a company uses its cash to buy its own shares from the open market, reducing shares outstanding and increasing ownership percentage for remaining shareholders. ### How Buybacks Work 1. Company announces buyback program (e.g., $10 billion over 2 years) 2. Company buys shares on open market 3. Purchased shares are retired (cancelled) 4. Fewer shares outstanding = higher earnings per share 5. Remaining shareholders own a larger piece of the company [EXAMPLE] A company earns $1 billion with 100 million shares outstanding. EPS = $10. They buy back 10 million shares. Now EPS = $1 billion ÷ 90 million = $11.11. EPS increased 11% without growing profits. [FORMULA] Impact on EPS = Earnings ÷ (Shares Outstanding - Shares Repurchased) ### Why Companies Buy Back Stock **Bullish signals:** - Management believes shares are undervalued - Strong cash flow with limited investment opportunities - More tax-efficient than dividends for shareholders **Neutral/concerning reasons:** - Offsetting dilution from stock compensation - Boosting EPS to meet targets (financial engineering) - Executive compensation tied to EPS [KEY] Buybacks at low valuations create value. Buybacks at high valuations destroy value. A company buying back stock at 30x earnings is very different from buying at 10x earnings. ### Buybacks vs Dividends | Factor | Buybacks | Dividends | |--------|----------|-----------| | Tax timing | Deferred until you sell | Taxed when received | | Flexibility | Can stop anytime | Cutting dividends is negative signal | | Benefit | Increases EPS, share price | Direct cash to shareholders | | Signal | Management thinks stock is cheap | Consistent cash return | [TIP] Look for companies that buy back more stock when prices are low and less when prices are high. This shows disciplined capital allocation. Companies that buy back at any price may be wasting shareholder money. ### Warning Signs [WARNING] Some buybacks are value-destroying: - Borrowing money to buy back overvalued stock - Buying back mainly to offset stock compensation - Large buybacks right before earnings disappointments - Management selling personal stock while company buys back ### How to Evaluate Buybacks Questions to ask: 1. Is the stock attractively valued when buybacks occur? 2. Is the company using cash or debt? 3. Are share counts actually decreasing over time? 4. Is management aligned with shareholders? [EXERCISE] Company A does $5 billion in buybacks over 3 years, but shares outstanding went from 500 million to 520 million. What's happening? |ANSWER| Despite spending $5 billion on buybacks, share count increased due to stock-based compensation to employees exceeding buyback pace. The buyback didn't benefit shareholders—it just offset dilution. This is common in tech companies. [SCENARIO] Two companies each earn $10/share and trade at $100 (P/E of 10). Company A buys back 10% of shares. Company B pays a 10% dividend. Which benefits shareholders more? It depends on your tax situation and the stock's future direction. If the stock rises, buybacks compound better. If you need income, dividends provide it directly. At the same dollar amount, buybacks typically have a slight tax advantage for long-term holders.