All else being equal, these programs should boost earnings per share (EPS). Here are three important principles for these programs.
Overall Growth vs. Growth in Earnings Per Share
A company’s decision to buy back its own stock is not based on the overall growth in profits. Instead, companies look at stock buybacks when they’re considering how to increase EPS. The latter is the all-important factor that can determine how fast equity in the company will grow. Here’s an example. Let’s say that Eggshell Candies, Inc., (a fictional company) has a market capitalization of $5 million (100,000 shares outstanding multiplied by $50 per share). Each share equals 0.001% of ownership in the company (100% divided by 100,000 shares). Let’s say you own just one share. This year, Eggshell Candies made a profit of $1 million, but management is upset by the company’s performance because the growth rate was 0%. That means the company sold roughly the same amount of candy and made the same amount of profit this year as it did last year. To address this disappointing performance, management decides to use this year’s $1 million profit to buy back shares in the company. This also helps ensure that shareholders make money, With this plan in mind, the CEO goes out the next morning and takes $1 million out of the bank. Then, they buy 20,000 shares of Eggshell Candies at $50 per share. The CEO then takes the issue to the board of directors, where a vote approves a plan to destroy the 20,000 shares. This means that now there are only 80,000 shares of Eggshell Candies in existence, instead of the original 100,000. What does that mean to you as an average shareholder? Well, each share you own no longer represents .001% of the company. It now represents .00125%. That’s a 25% increase in value per share. The next day, you wake up and discover that your stock in Eggshell is now worth $62.50 per share instead of $50. Even though the overall growth was 0% this year, individual shares gained value. And you made a 25% increase in your investment. This is the plausible near-term market reaction, assuming the buyback is well received. For the share price appreciation to hold firm over the long term, the timeliness of the buyback must prove sound.
Reducing Shares Boosts EPS
When a company reduces the number of shares outstanding, each of your shares becomes more valuable. It then represents a greater percentage of equity in the business. It’s like cutting the same pie with thicker slices. There isn’t more pie available, but it’s being split up among fewer pieces. In the corporate world, this “pie” includes all the benefits of holding a stock: company ownership, earnings per share, stock value, and more. This attitude of seeking to increase the slice of pie for existing shareholders is known as “a shareholder-friendly management style.” When putting together your portfolio, it can be a good idea to seek out businesses that engage in these sorts of pro-shareholder practices. Hold onto the stock as long as the fundamentals remain sound. Over time, your shares are likely to grow significantly in value.
Benefits Are Contingent on an Attractive Stock Price
In the example above, shares were priced at $50, and there’s an expectation that $50 is a fair price for the stock. Eggshell Candies wasn’t hitting all-time stock market highs. The price wasn’t overly volatile. Stock buybacks are not good if the company pays too much for its stock. Stock buybacks and share repurchases can be huge sources of long-term profit for investors. But they are actually harmful if a company pays more for its stock than it is worth. The same is true if the company uses money it cannot afford for buybacks. In an overpriced market, it would be foolish for management to purchase stocks at all, even its own stock. Instead, the company should put the money into assets that can be easily converted back into cash. Then, when the market moves the other way and shares trade below its true value, the company can buy back shares at a discount. This gives shareholders maximum benefit. Keep this old saying in mind: “Even the best investment in the world isn’t a good investment if you pay too much for it.”
Criticisms of Stock Buyback Programs
While share buybacks are generally a good thing for existing shareholders, they have not always been met with universal applause. For example, the Tax Cuts and Jobs Act of 2017 significantly slashed corporate tax rates, putting a lot of money back in corporate coffers. Many companies began using these newly available funds to buy back shares of their own stock. In December 2018, just before the end of the first year under the new tax law, U.S. companies announced that they had spent more than $1 trillion on stock buybacks. If you owned stock at this time, you likely experienced a boost to your portfolio. However, Gallup polls released in May 2019 suggest that just 55% of Americans own any stock, and that ratio has been fairly consistent in Gallup polls since 2010. That means nearly half of Americans experienced no benefit from the tax cut buybacks. Critics would rather see that $1 trillion spent in a way that benefits a larger number of people, such as investing in research and development, hiring workers, opening new locations, boosting employee salaries, or improving health and retirement benefits.
