Share buybacks have sometimes gained an undeserved bad reputation among politicians and several investors, since it often benefits the large owners and because many investors believe this gives a signal that a company has no growth potential.
But that a company has a stock buyback program, is in my eyes is something you should actually look for in a company before you invest.
How does the mechanism behind share buybacks work? And why do I think you should really understand the impact of buybacks, and why buybacks can have such a powerful effect on your returns?
In this article, you will get the answer to all these questions, as well as an example of how hefty returns you can actually get as a shareholder in a company that buys back its own shares regularly.
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What is a share buyback?
Buyback of shares means that a company buys back its own shares that it has previously issued, and cancels these. This leads to existing shareholders getting a larger stake, as the number of issued shares is reduced.
Since you get a bigger piece of the pie, it also means that you as a shareholder are entitled to more dividends per share, and is therefore a very good combination to look for together with the dividend rate in the company.
When a company buys back shares, your existing ownership increases as the number of shares in issue is reduced.
Why does a company buy back shares?
A company can choose to buy back shares for several different reasons.
The most important reason is that they see their own stock as underpriced, and that they therefore want to increase demand.
Share buybacks reduce the number of shares in circulation, and this can increase the share price and earnings per share (EPS). The latter is attractive to many investors, who often use EPS as an important key figure in their analyzes of a share.
To calculate EPS, you divide the company's net income by the number of shares issued. If the number of issued shares is reduced, EPS will therefore rise.
Example: If the company Thomas Kaffebar has a net income of, say, $1 million and there are 10,000 shares issued, the EPS is $100.
If, on the other hand, the company buys back 1,000 shares, the number of issued shares is reduced to 9,000, and EPS rises to $111
What are the benefits of share buybacks?
There are several benefits associated with buying back shares:
- Since the market value of the company is the same, but now distributed over a smaller number of shares, the price will generally rise. This certainly depends on several factors in the market, but is often a consequence of the buyback
- EPS will increase when the number of issued shares is reduced. This means that if you own shares in the company, you will be entitled to a larger share of the company's profit
Share buybacks thus give a company the opportunity to generate additional value for shareholders.
An example:
The company Thomas’ Kaffe has 1,000 shares issued, and you own 100 of those shares. You therefore own 10 percent of the company.
The company decides to run a buyback program and they want to buy back 100 shares from the market. This will reduce the total number of issued shares to 900.
If you do not sell your share, your ownership will increase by 1.11%. You will thus sit on 11.11% percent of the company's ownership instead of the previous 10 percent.
And that means: you are entitled to even more of the company's profits.
Example with Autozone's buyback program
Furthermore, you can see an example of how powerful a buyback program can be for you as an investor.
We take a closer look at the company Autozone, an American manufacturer of car parts that started fully buying back shares at the turn of 2000.
Since then, the shareholders' values have increased more than 10 times, without the company having had particularly explosive growth at all, with an average annual top line growth of a mere 6.5 percent.
Compared to the S&P 500, even with earnings at a snail's pace, Autozone has outright crushed the return on the stock market over the same period.
Over the past 20 years, Autozone has had a total return of 32315%.
For comparison: if you had put $10,000 on the S&P during the same period, you would have had around $50,000 today. $10,000 placed in Autozone would put you over $900.000.
Yes, you read that right.
How then have the shareholders managed to get so much back, even without much growth in the company?
Share buybacks, of course.
Autozone went from having over 150 million outstanding shares in 2000 to around 20 million outstanding shares today.
The reduction of outstanding stocks? 86 %!
I recommend that you check out this video as well, if you want to hear more about Stock buybacks. This is also where I got the story about Autozone from.
Where do you find share buybacks in a company's financial statements?
You can find this by seeing how many issued shares (shares outstanding) the company has listed in the balance sheet (balance sheet, in English).
Read also: shares for beginners: a great guide to investing in shares and fund
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