In his letters to shareholders, Warren Buffett has, on several occasions, written about the merits of share buybacks. When companies repurchase their shares, shareholders benefit because the value of their shares could increase. As US companies are sitting on large sums of cash that are not yielding much in the current low interest rate environment, returning cash to shareholders, through share buybacks, is a sensible corporate move.

When companies with outstanding business and confident financial positions find their shares selling far below intrinsic value in the market place, no alternative action can benefit shareholders as surely as repurchases.

Warren Buffett

This is how buybacks add value

Share buybacks shrink the number of shares circulating in the market. Post share buybacks, the profits of a company will be shared by a smaller pool of shareholders and each share will now have a larger piece of the earnings. In other words, the earnings per share (EPS), a key indicator of a company’s profitability, will increase after buyback programs.

EPS is an important factor in determining a company’s market valuation. A common valuation metric is the price to earnings ratio (i.e. P/E ratio). As the EPS increases, the P/E ratio falls. Unless fundamentals have coincidentally changed dramatically, said company would command a specific multiple irrespective of the buyback. If EPS rises, so has the stock price, otherwise, the P/E would fall. Thus the share price is expected to go up so that the P/E is roughly in line to what it was before the repurchase program.

Buyback yield is the expected long-term price increase due to buybacks

Not all buybacks are value-adding – look for high quality buybacks

Share buybacks have become widespread in the US. In 2014, American companies bought back more than USD 5501 billion of their shares and the momentum has continued throughout the recent years.

However, not all companies that conduct share buybacks are good investments. “On the contrary, just picking stocks based on the size of their share buyback program is not prudent. Some companies may be loading up on cheap debt to fund buyback programs to keep pace with competitors or as a way to prop up falling prices. These companies risk not being able to maintain their buyback programs and their share prices might fall”, says Jeremy Raccio, portfolio manager at UBS Asset Management.

It is important for investors to identify quality companies that have the ability to sustain share buyback programs through a solid business operation.

Jeremy explains that quality companies often display a number of common traits such as:

  1. Low financial leverage
  2. High return on equity and assets
  3. Low historical price movements
  4. Stability of dividend payments

Buybacks add value for shareholders, but prudent stock-picking is crucial for better returns.

Urs Raebsamen, Senior Equity Specialist