It's always worth reminding yourself how you make money from owning a share in a company. Financial returns can only come from two sources:
Return from a share = Change in share price + Dividends received
For me, the main reason to own a share of a company is that you are able to receive a slice of its profits. More often than not, a company pays its shareholders a dividend in order to distribute some or all of its profits. The great thing about dividends is that they represent a tangible return from owning a share - once it has been paid it cannot be taken away from you.
The same cannot be said for share buybacks which seem to be becoming increasingly popular alternative or addition to dividend payments. Share buybacks are when a company uses money to buy its own shares from other shareholders.
Share buybacks only work for shareholders if they boost the share price - something that the stock market can easily take away. It seems that company managements, professional analysts and the financial media think that buying back shares is universally a good thing. It is not that simple. Share buybacks are one of the most controversial and misunderstood topics in finance.
Quite often share buybacks give a much better deal to the company and its management. Shareholders are often left scratching their heads trying to work out how, and if, they are any good for them.
In this article, I am going to show you how to cut through the fog of share buybacks. If you own a share that announces a buyback you'll be able to work out whether it is good for your investment or not.
Phil shares his investment approach in his new book How to Pick Quality Shares. If you've enjoyed his weekly articles, newsletters and Step-by-Step Guide to Stock Analysis, this book is for you.
A share buyback is where a company buys its own shares on the stock exchange and cancels them to reduce the total number of shares in issue.
The justification for share buybacks can seem very powerful at first glance. By reducing the number of shares in issue a company can spread its profit across a lower number of shares and increase earnings per share (EPS). This might then allow it to pay a bigger dividend per share as well.
As lots of people value shares using price to earnings (PE) ratios, higher EPS can lead to a higher share price too. This is because the higher EPS after a buyback can lower a PE ratio and make the shares look cheaper than they were before. This attracts buyers who can push the share price up. As some investors prefer capital gains to income from a tax point of view (because they are taxed more favourably), surely share buybacks are a win-win for everyone? Not so fast. A higher EPS does not always mean that a company has become more valuable.
As I said just now, share buybacks have been growing in popularity in recent years and have been seen as a major reason for why shares have performed well since the financial crisis. Instead of using their cash flows to invest in new projects to increase their profits, many companies have been buying their own shares instead. The share prices of many companies that have done this have gone up a lot in the short run, but time will tell if this is money that has really been spent well.
What does a share buyback actually mean for you as a private investor?
For example you might be a shareholder in Marks and Spencer (M&S) and have come across the following comment from its chairman when it recently announced its full year results:
"In line with our policy, the Board is recommending a final dividend of 11.6p per share, resulting in a full year dividend of 18p, 5.9% up on last year. In the context of continuing increased free cash flow in the business we are also pleased to announce the start of an ongoing programme of enhanced returns for shareholders with a share buyback programme of £150 million in the current year."
You should be pleased that the company is going to pay you 11.6p of cash for every share that you own. You can spend that or possibly use it to buy more M&S shares. The bottom line is that that 11.6p is yours once it has been paid. It can't be taken away.
So what does this £150m to be spent on a share buyback do for you? £150m is equal to 9.1p per M&S share. You should be asking: Why couldn't this have been paid as a one-off special dividend and how does it make you better off by at least 9.1p?
For you to be better off, the buyback has to increase the value of M&S shares which you can turn into cash by selling them if you want to. This is not guaranteed to happen.
The cheerleaders of share buybacks tend to overlook one crucial and important point - the price paid for the shares when they are bought back. Remember, all investment is about getting a decent return on your money. Increasing EPS by buying back shares doesn't necessarily mean that you are doing this.
Let me show you how a share buyback works out in practice by looking at a fictional company called Bob's Book Store.
Bob has built up a very successful business over the years. He is making a very impressive £100m of trading profits every year but stiff competition means that this number is unlikely to change much. The stock market is in buoyant mood though and has given his shares a very punchy valuation of £1.6 billion or 20 times earnings (a PE ratio of 20) despite the low or non-existent growth prospects.
Bob needs to keep his shareholders happy. His advisors suggest buying back 10% of the existing shares in issue (in this case 100 million of them) so that earnings per share (EPS) can keep growing. So, instead of paying a dividend, Bob decides to use £160m (the equivalent of the next two years' post tax profits) to buy back shares at the price of 160p each instead. Look at the table below and the explanation underneath.
|Bob's Book Store (£m)||Before Buyback||After buyback|
|Taxation @ 20%||-20||-20|
|Post tax profit||80||80|
|Shares in issue (m)||1000||900|
|Earnings yield (EPS/Price)||5%|
|Market value (£m)||1600|
|No of shares bought||100|
Bob's shares are priced at 160p and there are 1000 million shares in issue giving Bob's Book Stores a market capitalisation of £1,600m.
Bob has £160m available cash which means he can buy 10% of his company's shares.
His post-tax profit of £80m is now spread across 900m shares giving an EPS of 8.9p - an 11.11% increase.
Company executives such as Bob like share buybacks because more often than not their bonuses are linked to higher EPS. They can be useful for offsetting new shares that have been issued for bonuses and share options. Company stockbrokers also encourage them because they can charge commission on all the shares bought back.
But lots of Bob's shareholders are not happy. It turns out that the shares were not worth 160p at the time. They were overvalued at this price because of their low growth prospects. They are now trading at 80p each - equivalent to a PE ratio of 9 on the higher EPS. The £160m spent on a share buyback has been a huge waste of money. The lesson here is this:
So what Bob was doing was paying 160p per share for a business that was only really worth 80p per share (8p x PE of 10 before the buyback). Look at the table below. You can see that, in doing so, he reduced the true underlying value of the business to just over 71p. If he had paid 75p then he would have increased the value of the business. The effect on EPS is irrelevant. By paying too much, Bob has destroyed a large chunk of shareholder value just as many company managements do in the real world.
|Bob's Book Store||Buying back at 160p||Buying back at 75p|
|True value per share(p)||80||80|
|Shares in issue (m)||1000||1000|
|Value of business (£m) = A||800||800|
|Shares bought (m)||100||100|
|Cost of buyback (m) = B||160||75|
|Value of business after buyback C = (A-B)||640||725|
|Shares in issue(m)||900||900|
|New true Value per share(p)||71.1||80.6|
Spending cash on buying back shares reduces the total value of the business (because you have less cash). Value per share only goes up if the business value shrinks by less than the reduction in the number of shares. You can only do this by buying back shares for less than they are worth.
Getting back to Marks & Spencer, its buyback will only make its shareholders better off if the current share price of 580p is less than the real value of the business. The trouble for you and me is that there's no way of accurately knowing this. Fortunately, there is another, more practical way to work out if a share buyback could be good for shareholders or not.
One of the best ways of checking out the merits or otherwise of a share buyback was set out by fashion retailer Next in its 2012 annual report. It looks at what it calls the equivalent rate of return (ERR) - what return the company would need to get on an alternative investment to achieve a similar increase in EPS from buying back its own shares.
Most people can understand interest rates and that a high interest rate is better than a lower one when it comes to investment returns. This is what makes Next's explanation so useful as hopefully you will see.
Next calculates that an ERR of at least 8% is needed to justify spending cash on its shares. You can interpret this as Next saying that its shareholders require at least an 8% return on investment when they (Next) spend money. It applies the same rate to new stores.
To work out the ERR of a buyback you need four pieces of information about a company all of which you can find in SharePad and ShareScope.
The table below and following explanation show you how to work out the ERR and whether a share buyback has created or destroyed shareholder value.
|Market Cap||£11490m||Share price x no. shares|
|Cash (for BuyBack)||£300m|
|% shares acquired||2.61%||Cash / market cap|
|EPS enhancement||2.68%||1 divided by (1 minus % shares acquired)|
Company pretax profit
|Profit needed for equiv. EPS increase||£22.26m||EPS enhancement x pretax|
|ERR||7.42%||Pretax increase / cash|
What's the most it should pay
|Required return on Buyback||8%||Min return required|
|Required profit||24||Cash x ERR (8%)|
|% of company to Buyback||2.81%|
|Shares needed||4.30m||Current no of shares x 2.81%|
|Price to pay||6983||Cash spent divided by shares needed|
Essentially, if Next spent £300m of surplus cash buying back its own shares at £75.15 this would increase EPS by 2.68%.
Next would need to increase pretax profit by £22.26m in order to achieve the same EPS increase. A £22.26m return on £300m would be an equivalent rate of return of 7.42%.
Next has stopped buying back its own shares because the ERR is below its 8% target. To get an 8% return, the most Next should pay for its shares is £69.83.
Don't worry too much about the calculations. If you want to use this model yourself, we have provided a spreadsheet for you at the end of this article so you only have to input the key numbers and everything else will be worked out for you.
This 8% minimum return figure is reasonable for large, established companies that you might find in an index such as the FTSE 350 or S&P 500. For smaller and riskier companies you might want to use a higher minimum return to reflect this. I'll have more to say on this subject in a future article as it is one of the most important issues in investment.
You can do this type of analysis for any share to see if a buyback makes sense. This is how the numbers stack up for Bob's Book Store.
|Market Cap||£1600m||Share price x no. shares|
|Cash (for BuyBack)||£160m|
|% shares acquired||10%||Cash / market cap|
|EPS enhancement||11.11%||1 divided by (1- % shares acquired)|
Company pretax profit
|Profit needed for equiv. EPS increase||£11.11m||EPS enhancement x pretax|
|ERR||6.94%||Pretax increase / cash|
What's the most it should pay
|Required return on Buyback||8%|
|Required profit||12.8||Cash x ERR (8%)|
|% of company to Buyback||11.35%|
|Price to pay||1.41|
Bob may have paid too much for his company's shares. The ERR at £1.60 is only 6.94%. To get a minimum 8% return the most he should have paid for them is £1.41. But even this may have been too much if the true value was only 80p.
I like this ERR test and think it is an extremely useful way of looking at the merits of a share buyback. That said, just because a company is getting a reasonable return it doesn't necessarily mean that a buyback is making shareholders better off. They can still be paying too much.
For example, existing assets might earn returns of 20% (look at return ratios to check this out) and so a buyback giving 8% doesn't look too good. Have a look at the valuation the buyback is taking place at. Is the PE ratio a lot higher than the share's historical average?
That's why giving the money back to shareholders with special, one-off dividends might be a more sensible thing to do. They are less likely to be confused and more likely to be better off. It is encouraging to see that companies such as Next and many house builders and insurance companies are doing this.
|Company||Price(p)||Size of buyback (£m)||Eps boost||ERR||Price Limit(p)||Share price vs Limit|
|Aberdeen Asset Management||441||100||1.73%||9.6%||528||-16.44%|
I've had a look at the share buybacks that have been announced by some companies recently and subjected them to the ERR test. I've worked out what would be the EPS enhancement and ERR if the shares were bought back at current prices with surplus cash. I've also worked out a maximum price to pay to achieve a minimum 8% ERR. Aberdeen Asset Management's and BT's pass the 8% test but Marks and Spencer's does not. Have a look at the valuations of these companies compared to their historical valuations, and their return ratios, and see whether you think these companies are really doing the right thing or paying too much for their own shares.
We've included a handy buyback calculator below. To edit the values, simply double-click on the relevant cell and enter a new figure.
You can also download or view a full-size version of this buyback calculator via the ribbon (the black, horizontal bar directly below the spreadsheet).
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This article is for educational purposes only. It is not a recommendation to buy or sell shares or other investments. Do your own research before buying or selling any investment or seek professional financial advice.