I was sitting here today thinking and I realized I've never fully grasped why share buybacks from both the seat of an investor and as a capital allocator at a company are good thing. I understand conceptually why returning capital to a shareholder is a good thing....but in terms of understanding returns, I'm having trouble grasping how to measure the impact of a buyback program.
First as an allocator, I think this one is a little more straight forward but looking for confirmation here. If I have a set of investment opportunities that range from 10-20% rates of return, consider the fair value of my equity to be $30/share and yet it's trading at $20/share...then as an allocator (in a vacuum) I would opt for the share buyback as if my internal valuation is correct, I would be investing in a 50% rate of return opportunity? Is that fair to say?
As a shareholder though, how am I incorporating share buybacks into my overall return? For dividends it's easy....at $20/share if I get a $2/share dividend, I'm yielding 10%. But how do I layer in the returns due to share buybacks? Unless I'm tendering shares as part of the buyback program, I'm not really receiving any direct return in form of consideration, so where are the returns the shareholder returns that companies are quoting being derived from?
Ultimately, most forms of capital allocation are pretty theoretical and don't pan out the way you want them to in reality. Share buybacks are an easy way to provide better liquidity for shareholders who want to cash out on their returns (hence providing direct value back to them), and reducing float (consequently increasing earnings per share). Theoretical ROIs from internal projects is all well and good but I think those of us in finance forget about the operational difficulties of running a business - in times like this, returning cash back to shareholders is a more low risk use of cash than internal projects, according to several management teams (at least within the industry I cover).
Apart from whatever has been said above:
https://knowledge.insead.edu/economics-finance/share-buybacks-are-corpo…
This article from INSEAD talks about instances with IBM and GE where buybacks didn’t materialise the way management would’ve wanted.
In the short run, you could say a CEO who’s leaving in a year or so might be incentivised to repurchase shares so as to boost his pay package (performance bonus for example)
If the company earns the same amount of money but now it is spread across less shares than each share remaining will have a higher EPS and dividend per share, therefore making each share more valuable to those holders
This is wrong. Share buybacks don't increase share price lol. Decline in shareholder equity exactly offsets increase in EPS.
So the dude says buybacks lead to higher EPS
You confidently say it's wrong and then share an example showing buybacks increasing EPS...
Why would your P/E drop from 15.0x to 13.8x immediately after a share repo? Nothing operationally changed with the company - they're still producing widgets at the same pace and cost as the day before. Only difference now is capital structure has changed (and net debt too).
Assuming your Net Income estimates are forward looking (so you'd receive that $6mm in interest income in the status quo scenario), why are you using Share Price to back into P/E? Earnings dictate equity value, not the other way around.
So correcting for that error....
$94mm in NI by EoY
x
15.0x P/E Mult
= $1,410 Market Cap
/
86.7 FDSO
=
$16.83 per share
Don't over-complicate this. Buybacks cause share count to decline (which is those shares that others tender), which means each remaining share is entitled to more earnings (i.e. higher EPS). Which enhances your total return. For instance:
Say there were 100 shares with $1 EPS per share ($100 market cap). Say 50% of it was bought back. Now you have 50 shares but still $100 aggregate earnings, so per share earnings is now $2. You now have double the EPS you had before. Congrats
Buybacks are an excellent capital allocation strategy is there aren't higher ROI opps elsewhere (i.e. investing in the core biz, buying another company where there are clear synergies, etc). Lot of strong companies have the capital needed to do both. THey'll invest in high organic ROI opps first, then use excess CF for buybacks which makes sense
This is wrong. Share buybacks don't increase share price lol. Decline in shareholder equity exactly offsets increase in EPS.
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In terms of the math, the way I think about it is your rate of return is the:
{new implied share price = (old market value of equity - cash spent buying back shares) / (old share count - # of repurchased shares)}.
This can be challenging to assess, since most boards give a $ value they plan to repurchase and then often don't actually meet that number. So theoretical rate of return could be seen as that equation. % Return = {(new implied share price / old share price) - 100%}
Additionally, don't neglect how this will impact earnings. I won't do the math here, but income statements will generally change as a result of buybacks somewhat.
Whether this will be beneficial or not is a different story (i.e. compared to buying another company, paying a dividend, etc.). Managers are notoriously bad at timing when to do repurchasing, often buying back stock when it is expensive rather than cheap (take a look at share repurchases broadly among S&P 1500 companies around 1994-1997 when they first became popular vs. 2001-2003 when they nearly died out).
As an aside, contrary to popular belief, high ROI internal opportunities are not always the best place to allocate capital first. My thought on this is that politicians, having seen that investing in their campaigns generally helped them win, want to bring this idea to the rest of the world. Sometimes a good dividend or buyback (especially when the stock is cheap) will create more money for shareholders. What happened with GE (and namely GE Capital) and its current situation is a great example of putting money in the wrong places internally and suffering the consequences.
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