As is the common theme with all of the posts I make, I try to assign a unique title to each one of them. And while I certainly feel like I am selling my soul to this hobby of mine half the time, which is now at its 85th post, I am definitely not the topic of this conversation. This lesson looks at the concept of share buybacks, and why companies engage in this activity and what effect it has on their shareholders, and to market watchers. Let’s first look at how shares come about in the first place.
Companies raise money (capital) by doing one of two things: by issuing debt, or by equity. The equity piece can be simply through retained earnings (left over cumulative positive net earnings) or through issuing shares or ownership of the company for a price. Issuing shares to the public at the market price is one way for a company to raise capital for the purpose of hopefully growing their asset base, and improving the long-term performance of the company. Shares outstanding showcase how many shares a company has issued to the public to buy in order to raise capital.
Markets don’t look too favorably upon companies issuing shares in order to raise funds. This can be indicative of a number of things. First of all, this puts into question the company’s ability to get financing at a cost of capital that they can afford… why revert to issuing shares if taking on long term debt is an alternative? What does the current capital structure of the business look like? Is the company already very levered, or does it have a low interest coverage ratio? Is there a solvency or going concern risk with the company given its current debt obligations? Do rising interest rates pose a risk if large portions of long-term debt are coming due for refinancing?
The other primary knock against companies raising money through issuing shares is the impact that this has on existing shareholders. The effect of issuing new shares to public markets is dilutive to existing shareholders. If I owned 10% of a business today, and tomorrow the company issues new shares for purchase and effectively doubles the shares outstanding, my ownership has now diluted to 5%. The company is relying more on outside financing by giving up ownership of its business to the public in exchange for capital. This also has dilutive effects on many financial metrics such as Earnings per Share, Free Cash Flow per share, and other “per share” measurements. The return an investor gets for every $1 invested in the company has now decreased with the company’s issuance of new shares for purchase. This could also affect the dividend per share that existing shareholders were once receiving. If X dollars were available before for dividend payout, that same X dollars is still available now, but will have to be distributed amongst a larger pool of shares than before.
Now the flip side is typically seen by the markets as very favorable. Companies who are buying back their shares (i.e. share buybacks) are doing this for many reasons. One of the primary reasons being is that management believes their company stock is very cheap and undervalued. A company could theoretically buy back shares at say $20/share, and then at a later date, issue these same shares back to the public at $40/share. Executive management may also want to reduce the ownership of the company by the public, and want to increase ownership within the company for private ownership (perhaps amongst the original seed and angel investors, or executive management, founders, or current employees). Share buybacks are not only a signal that a company is undervalued, but that the company has excess cash reserves that it is putting towards retaining ownership back to the original private owners and employees. A company decides to publicly list on a stock market exchange to relinquish sole ownership from its original investors to the public in exchange for quick access to, and exchange of, ample capital. Buying back shares indicates that a company does not need to rely on public issuance of shares in order to raise capital, and can fund its own capital investments simply through the normal course of debt issuance or through years of cumulative net positive earnings (positive retained earnings). Contrary to issuing new shares, reducing shares outstanding will, even with a level net earnings trend, increase the earnings per share for existing investors, and make the company look more attractive from an overall valuation perspective and likely result in upward pressure on the stock price.
Share buybacks and dividends are the two main ways companies return excess capital back to shareholders. Another motivation for companies to focus on share buybacks is that they are more tax advantageous than dividends for the investors who have to pay taxes on dividends. As the Washington Post explains, "Buybacks are far more tax efficient for companies since dividends are taxed twice -- once as corporate income and again as dividends. Buybacks are only taxed once. Taxes on buybacks would have to increase dramatically — perhaps to about 10% — before it made sense for a company to declare a dividend instead."
When looking at which companies to invest for the long term, truly consider the share buy back trend over the last 10+ years. Has the company consistently bought back shares from the public year over year? Or is the company continuing to issue new tranches of shares year over year to fund various capital endeavours? Look for companies with stable outstanding share balances, and ideally, with a history of consistent periodic share buy back programs. Berkshire Hathaway, Apple, T-Mobile, Microsoft, Oracle, Google, Regeneron Pharmaceuticals, and Bank of America are large companies that are actively engaged in consistent share buy backs programs, to name a few.
You shouldn’t feel as if you’re selling your soul to the companies you invest in because of constant dilution from continued new share issuances time after time. Rather, you should feel a proud sense of ownership in where your money sits and how it is being used to fund operations of a company and grow its business. What better way to feel like this by seeing your ownership fraction of the pie slowly growing over time by sitting idle and watching your next egg grow.