Share buybacks are a controversial topic, in part because they are not well understood. This article will explain stock buybacks and summarize key finding from recent research by Two Sigma: Share Buybacks: A brief Investigation.

Q: What is a share buyback?

A share buyback occurs when a company buys back their own shares in the public market. Companies normally invest cash into projects internally. Generally, these projects will have a minimum acceptable rate of return. When a company has more cash than profitable projects it may choose to return the cash to shareholders. The company can return the excess cash to shareholders by paying a re-occurring or one -time (special) dividend or they can execute a share buyback.

In a share buyback, the company buys its own stock shares back. From accounting standpoint, the company has reduced cash and reduced book value of equity outstanding. The shares are issued but not traded and are referred to as ‘treasury stock’ under ‘owners equity’ on the balance sheet.

Assume the company continues to generate the same profit it had prior to the buyback, the earnings per share of the company increase. Let’s say a company is generated $1/share of earnings per year. If the company buys back 10% of the share, the number of shares outstanding is now 90% of the prior level. As a result, the earnings per share is now 1/.9 or $1.11 per share. Buyback yield for a company is the amount of shares bought back in the year divided by the original shares outstanding.

Q: What is the impact to investor return for a share buyback?

In theory, if the company continues to generate investor required rates of return, the price outstanding shares should increase to adjust for the reduced shares outstanding. Financial leverage of the company has increased (debt/equity is higher now that we have reduced equity). This may result in higher price volatility.

This is a key point with emphasizing, a share buyback should result in higher stock price appreciation going forward compared with a scenario where a company pays a cash dividend instead. The company has simply reduced the denominator in the Earnings per Share calculation. We should see price appreciate in the stock price over and above the case where a cash dividend is paid.

Q: Which is better for investors, a dividend or a company share buyback?

In the US, dividends are taxable in the year they are received at a rate between 15% – 23.8% (unless your income is under $39,475). A share buyback does not result in immediate taxes.

On the other hand, if the company executes a share repurchase, we have no cash in hand but we will hold shares in the company should rise faster than if a dividend is paid. We won’t pay taxes until we actually sell shares. This option is riskier than cash but, has potential for tax deferred returns.
Both dividends and stock buybacks reduce the cash position of the company. The dividend gives the investor certain cash while the share buyback returns come through the potential capital share price appreciation.

Q: What if the investor needs income to live on, isn’t a dividend better?

This should not be a primary reason to buy a company that pays a dividend. Here is why. Say we can invest in company A that pays 2% dividend. Company B is exactly like company A in every regard but does not pay a dividend. Over time, we would expect higher share price appreciate from company B. We can create our own dividend by selling a few shares when we need to!

Q: Don’t share buyback distort company earnings growth per share?

One argument you hear often is that companies which buyback shares are manipulating their earnings to show higher earnings growth per share. It is true that year-over-year EPS growth will be higher for a company with share buybacks. It does make it more difficult to fully evaluate a company. However, to value a company we need to look variety of issues from organic revenue and earnings growth to long term prospects. Share buyback require the analyst to understand additional parameters that affect the value of the company but, in and of themselves they are per se bad. Analysts or investors who naively look at EPS growth without understanding the contributing factors will likely run into problems because buyback yield will not be sustained over indefinite periods.

Q: What more can we learn by looking at the companies involved in share buybacks?

The research noted above investigated a number of very interesting questions. Which companies are more likely to announce a buyback? Will companies that announce a buyback generate excess returns in the months following the announcement?

One major finding by the report is that the behavior of the market with respect to stock buybacks has changed since the financial crisis in 2008-2009. There is debate over why the change occurred. It could be that the market is more efficient in reacting to the share buybacks. To keep things simple, I will discuss findings for stock buybacks since 2008-2009.

Q: Does recent past performance help predict which companies will announce a buyback.

Yes. The research found that companies with positive returns as measured by the sharpe ratis (return / risk) computed over 12-36 months prior to announcement were more likely to announce a buyback. Companies with the most positive sharpe ratios were roughly twice as likely to announce a buyback. Approximately 3% vs 1.5% on average.

Also, companies that have experienced recent negative performance over 6 months compared with 36 months were more likely to announce a share buyback program. A share buyback announce could be a signal to the market that management believes the price is under-valued. It may also signal that the company is in good enough financial shape to be able to buy the shares.

Q: Is there evidence to support the idea that stronger companies are the ones to announcement buybacks?

According to the research, companies with the best fundamentals are more likely to buyback shares.

“Stocks announcing a share buyback tend to have significantly stronger fundamentals than average, with higher scores on Earnings Yield (i.e., lower price-to-earnings ratio), Earnings Quality (i.e., more cash earnings), and Profitability (i.e., higher return on equity and return on assets). These firms also tend to be larger (positive Size and Mid-Cap loadings), with lower Leverage and lower market-implied risk (both lower Beta and lower Residual Volatility).”

Q: Do stock buybacks help predict future excess returns?

Yes! The cumulative average abnormal return in the six months before announcement were -1.5%. In the subsequent six months including the announcement month, the cumulative average excess return from the low point was ~2%. It appears that companies who buyback shares have had good recent 3-year performance, hit rough patch, announced a share buyback and then recover all of the recent decline and a bit more.

Q: How can investors use this information?

First, based on research we know companies with good fundamentals and earning momentum outperform. I see the share buyback announcement as providing one additional piece of information that may help to decide when to buy or sell high quality companies. In other words, first choose the companies you want to own. If the company happens to be buying back shares or announces a buyback be sure to factor in the buyback yield contribution to EPS growth. The decision when to buy could be bolstered by a recent share buyback announcement.

If you’d like to see a list of recent buyback announcements check out this web site: https://www.marketbeat.com/stock-buybacks/

If you are interested in individual stocks and would like to discuss further, please feel free to give me a call!