What are share repurchases?
Most companies start out as private companies. When they get big enough, the owner might decide to sell his company, or he may decide that if he had a lot of extra capital, he could put it to good use in expanding his business. So, a private company can decide to offer an Initial Public Offering (IPO) where they sell some of their company to the public and therefore become a public company. Of course, the company is expensive, so it’s broken up into manageable pieces called shares. A typical public company consists of millions (or even billions) of shares. Sometimes public companies offer additional shares at a later date that further increases their total number of shares. This can be because they offer shares as compensation to certain employees, or because they want to pull in some extra capital for a perceived investment opportunity.
The problem with a company increasing the total number of shares is that it makes each share worth a smaller percentage of the company (diluted), and shareholders might become angry about that under certain conditions. Since each share is a portion of the company, increasing the total number of shares means that each share now represents a smaller portion of the company.
Inversely, company management can use money earned from operations to repurchase company shares, which is called a share repurchase. A company can either make direct offers to shareholders for share repurchases or they can buy their own shares on the open market. After a share repurchase, the shares are either cancelled or held as treasury shares, and are therefore no longer held by the public and are not oustanding. This effectively reduces the total number of company shares in existence, and therefore each share is worth a larger percentage of the company (and correspondingly, the stock EPS will increase and therefore the P/E will decrease or the stock price will go up).
Why do companies do share repurchases?
When a company has excess capital from their operations, they can use that money to do several things:
-Reinvest in core growth
-Improve the balance sheet
The majority of established businesses cannot possibly reinvest all of their income into core growth and achieve an effective rate of return on all of it. The law of diminishing returns plays a part; a certain amount of invested capital will drive significant growth, while further capital will not be as effective. A company has a finite number of ways to improve in a given year, and so if they try to use every dollar they have for core growth, they’re going to end up investing in a lot of their second-rate ideas.
Acquisitions are another option. Acquisitions, when performed correctly, can provide a lot of value to shareholders. The problem is that acquisitions aren’t usually as profitable as core growth because the purchasing company typically pays a premium for the company they are buying. Their return on investment simply isn’t that good with acquisitions. Some CEOs get into the habit of “empire building” where they increase the size of their company simply for the sake of building a legacy and/or getting a bigger paycheck as a CEO of a larger enterprise. Company size increase is usually good, but what shareholders are mostly interested in is the total return they receive as being the shareholder, and empire-building is usually not the most profitable path. Quality is better than sheer quantity.
Improve the Balance Sheet
A company can use capital to pay off debts and reduce the amount of debt they are taking onto their balance sheet. They can also improve their cash position to keep their options open. Many dividend companies already have excellent balance sheets, so building it better might not be in the shareholders best interests. Many established companies even purposely seek out a little bit of leverage- think companies like Coca Cola, Johnson and Johnson, and Wal-Mart. They’ve been very profitable for a very long time and could have had zero debt on their balance sheet by now if they chose to. All of them have strong balance sheets, but they do utilize some debt to increase overall shareholder returns. If a company can borrow money at 5% and use it to generate 10% in returns, it makes sense to do so as long as they keep their balance sheet strong by not taking on too much leverage.
Once a company has exhausted its options for profitable core growth and acquisitions, and has a strong or improving balance sheet, the company should be sending capital back to shareholders. That’s one of the two primary reasons to operate a business- to make money for the owners (the other primary reason being to provide a valuable product or service). Dividends represent a portion of the profits sent out to shareholders as passive income. Most American dividend stocks pay out quarterly dividends, and many companies focus on raising their quarterly dividend each and every year. Other companies pay twice annually, or on other schedules, or don’t necessarily raise their dividends each year. There’s also the option to pay a special (non-regular) dividend to shareholders on various occasions.
A company can choose to repurchase its own shares. There are several reasons to do this:
Improve Company Metrics
Using money in a share repurchase reduces the total assets of the company, and so their metrics like Return on Assets and Return on Equity will improve (compared to not repurchasing shares).
Demonstrate Per-Share Growth
Reducing the total pool of shares means that Earnings-per-Share (EPS) will grow more quickly than company-wide earnings. The same is true for revenue and cash flow. If a stock’s P/E ratio remains constant, but EPS increases, then the stock price will increase.
Fuel Dividend Growth
If a company pays out the same amount of total money to shareholders each year in dividends, and the number of total shares is decreasing, then each shareholder will be receiving a larger dividend each year. And if the company is actually growing earnings and its total dividend payout, decreasing the total number of shares will be able to boost the dividend growth even further.
Flexibly Return Value to Shareholders
American companies that pay regular dividends are basically obligated to keep doing so. Many companies are very proud of their long records of consecutively raised dividends, perhaps stretching back 10, 25, or even 50 years. If they ever encounter a period where they have to cut their dividend, they’ll ruin their long record, generate bad press, and anger dividend investors. So, companies typically keep their payout ratios fairly low, perhaps in the 20-70% range, so that even if their profit drops substantially, they’ll be able to keep growing their dividend. Share repurchases are often used to the fill the gap between excess capital and dividends, so that the company can return more to shareholders without being locked into a pattern.
So, for instance, if a company wishes to return 75% of its earnings to shareholders, but wants to keep its dividend payout ratio at 50%, then it could return the other 25% in the form of share repurchases to complement the dividend.
Company Example of Share Repurchases:
Monk Mart Industries (symbol: MONK) is my fictional company. It consists of 100 million shares, and each share is currently trading for $50 each. So, the market capitalization of the company is $5 billion.
Each year, the Chief Executive Monk receives a bonus of 500,000 shares, and the 15 vice presidents each receive 100,000 shares. This means that each year, the total number of Monk Mart shares increases by 2 million. Since the company currently consists of 100 million shares, in one year the company will consist of 102 million shares, and the year after that, the company will consist of 104 million shares. After 10 years of this, the company consists of 120 million shares.
In the current year, the company consists of 100 million shares. Assume for the example that the company currently has $500 million in annual profit, so the EPS is $5.00. In ten years, when the company consists of 120 million shares, assuming the company has managed to grow its earnings to $900 million, the EPS is $7.50. This means that although the company managed to grow its earnings by an annualized 6% per year over this ten year period, the EPS only grew by 4% per year due to share dilution.
After seeing this, shareholders are beginning to become annoyed at the share dilution. So, Monk Mart executives and directors decide not only to have the company repurchase enough of its own shares to cover their bonuses, but also enough to continually increase the total value of each share. So, they being repurchasing 6 million shares each year in addition to continuing to issue their bonuses , for a net share repurchase of 4 million shares per year.
After ten years of repurchasing 4 million net shares each year (and therefore 20 years after the beginning of this example), the company now consists of only 80 million shares. In addition, the earnings are now $1.6 billion. The EPS, then, is $20. Over this ten year period, the company has increased earnings by 6% per year, but EPS has grown by more than 10% per year.
As can be seen, company shares represent a dynamic system. The total number can fluctuate over time. Some companies may let share dilution occur, while other companies may reduce total shares to increase overall shareholder returns.
There are two sides to every story. Sometimes allowing the total number of shares to increase is a good thing and leads to a larger, better company, because management puts the capital gained from sale of equity to good use. Excessive executive compensation, on the other hand, is typically not in the best interest of shareholders. In addition, if shares are diluted and the capital is invested poorly, then that is also bad news for shareholders. On the other hand, reducing shares at a bad time can not be in the best interests of shareholders either. For instance, if a company pays high prices for its own shares, then it’s not using shareholder capital effectively.
Most effective company managers will make smart decisions regarding share repurchases and share dilution. Managers that are less concerned with creating shareholder value might not. Unfortunately, even some good managers can make poor repurchase decisions.