Stock Buybacks: What That Means For You

By Joe Ponzio on September 27, 2007  |  8 comments

When buying a business, you are essentially becoming a silent partner in that business. Sure, you have a say in the meetings and you get the annual reports; still, you don't have any real control over the day-to-day operations or the allocation of the company's (your) cash.

When a company buys back stock, it is using your cash to increase your ownership by reducing the number of outstanding shares. You end up with a bigger piece of the pie. That's a good thing, right?

Casey had posted this comment:

One topic I have not seen you address. Share buybacks and the effect on shareholder equity. Esp. the effect on your equity growth calc. When a company undertakes a significant buyback the equity in effect goes down due to accounting regs...I guess if you could give me some thoughts on addressing the buybacks that would be great.

The Buyback Effect On Equity

When a company buys back stock, it puts those shares in its treasury—stored to be later retired or resold to raise more money. Treasury stock is not entitled to receive any dividends, is not used to calculate earnings per share, and can not be voted.

In a stock buyback, the company is essentially trading its cash for stock. At the end of the transaction, our company no longer has that cash; but, we also own a larger piece of the entire company.

A Larger Piece of What?

If you own 100 of XYZ Company's 1,000 shares, you own 10% of the company. When it buys back 100 shares (assuming you don't sell yours), you now own 11.1% of that company—100 shares out of 900 outstanding.

But here's the kicker—buying back shares results in less assets and lowered shareholder equity. That can be great—or horrible—for shareholders.

The Ideal Buyback

In an ideal world, your company will only buy shares back when they are selling at a discount (preferably a deep discount) to their intrinsic value. In doing so, your company would essentially be buying back $1 of its business for $0.50—greatly increasing your interest in the future value of the business.

The Almost Ideal Buyback

The other way your company can wisely reward you is by using its excess cash to repurchase shares because it does not expect much more growth. Rather than pay you a taxable dividend, it can increase your ownership and money by giving you a larger piece of the pie.

The Institutional Imperative

Unfortunately, many businesses buy back stock because they see other companies do it and think that they should. When this happens and stock is repurchased at any price, it may end up hurting your return rather than enhancing it.

How To Represent This On The Spreadsheet

When looking at a valuation spreadsheet or analyzing past shareholder equity, you are trying to find consistency in the business. The true value of the company lies in the future.

If you see shareholder equity declining, but you know that it is due to stock repurchases (rather than the accumulation of too much bad debt), don't fret. Your business might be doing something good.

But here's a thinking point: You want to identify growing businesses with solid moats. Why is that company buying back shares? Is management having a hard time allocating cash? Does the board see value in the current stock price? Or, are they just morons?

Most are just morons.

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