Share Repurchases: Why Companies Buy Their Own Stock

Why do companies buy back their own stock?  Today’s article is going to explain how share repurchases work and what it means for existing shareholders.

Imagine that you are one of 10 business partners and your company earns $1 million for the year. Your company has to decide what to do with the earnings. Here are the options:

  1. Pay $100,000 to each of the owners in the form of a dividend. Owners love receiving dividends, so this is always an attractive option. Most mature, slower-growing companies, such as utility companies, pay dividends.
  2. Reinvest the earnings in the business (e.g., open new offices, buy more equipment, hire additional employees, etc.). This makes sense for fast-growing businesses.
  3. Use the earnings to buy out one of the partners.

Why are share repurchases suddenly so popular?

This third option, share repurchases, has been extremely popular this year among publicly traded companies, especially if your company has a high valuation. In fact, companies spent $516 billion buying back their own stock in the first nine months of 2015. This is the highest level of repurchases since 2007, and 2015 could prove to be the biggest year ever for share repurchases. Low interest rates and record amounts of cash on company balance sheets are one of the reasons why share repurchases have been so popular this year.

Looking at our example above, let’s suppose that we could buy out one of our partners for $1 million. Each partner foregoes the $100,000 that he or she was entitled to this year, but next year, if the company earns the same $1 million, it would only be split nine ways. This means that each of the remaining partners would get $111,000 instead of $100k. That is an 11% annualized return on the $100,000 each partner invested in the buyback, assuming the company continues to earn the same $1 million each year. Now consider that public companies are only earning around 1.3% on the cash on their balance sheets (according to Howard Silverblatt, an analyst at S&P Dow Jones). Investment grade public companies can also borrow money these days at an interest rate of approximately 3% (by issuing 10-year bonds). So, why not borrow money and use it to buy back shares? The hypothetical example of buying out one of my 10 partners for $1 million means that the company is valued at 10 times earnings. Even at 15 times, this makes sense when you can borrow the money for 3% or use surplus cash that is only earning 1.3%.

Shareholders tend to like share repurchases for two reasons:

  1. They indicate that the company’s shares are undervalued in the eyes of management.
  2. They are a sure way to increase earnings per share. Let’s face it; most investors do not look at overall earnings. They just focus on earnings per share.

One complaint is that some companies should be investing more for their future instead of focusing on short-term financial engineering to boost their stock price.  This has been a recent critique against pharaceutical companies that are spending more on dividends and stock repurchases than on research and development (R&D).   Watch this two-minute video on share buybacks to reinforce or clarify how repurchases work.