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Whenever a public company generates a profit, it is left with an important decision - what to do with the additional cash. Companies have three major options available:

  1. Retain earnings
  2. Issue a dividend
  3. Share repurchases

Many companies participate in a combination of the three. The first option allows the company to re-invest back into the business, whereas option 2 and 3 allow for some of the money to be returned back to shareholders. Returning capital to shareholders offers an efficient way to increase value for shareholders; however, share repurchases, in particular, come with consequences, which may end up deceiving unaware investors.

Share repurchases, or share buybacks, allow for a company to buy back its own shares in the open market. Companies have different motives for initiating share repurchases, some self-serving (ie. protection from unfriendly takeovers), others, with shareholders interests in mind - ensuring stock options don't dilute shareholder value. Regardless of the reason, they ultimately increase the value of each share, by reducing the total number of shares outstanding. On the surface this seems entirely beneficial to shareholders; however, share repurchases have another underlying deceptive effect. When a company buys back shares, many popular fundamental ratios are affected, even though the underlying fundamentals remain unchanged. By distorting these ratios, year-to-year comparisons become a lot less meaningful.

The table below shows the EPS and P/E ratio for Coca-Cola Enterprises (NYSE:CCE), ConocoPhillips (NYSE:COP), Exxon (NYSE:XOM), IBM (NYSE:IBM), Intel (NASDAQ:INTC), Motorola (NYSE:MSI), Wal-Mart (NYSE:WMT) & Wynn (NASDAQ:WYNN):

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All of the companies listed above participated in a share repurchasing program during 2012, reducing outstanding shares anywhere from 5 percent to 17 percent:

The tables below show how share repurchases affected the EPS and P/E ratio:

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As shown above, by participating in a share buyback, the company reduces the number of shares outstanding, effectively reducing the denominator in EPS, causing EPS to increase. As EPS grows, the P/E ratio falls. The company now appears more profitable, with a higher EPS, and better valued, with a lower P/E. This however is not the case. The company didn't earn any more money. The fundamentals of the company have not improved; all they did was reduce the number of shares outstanding.

Many news publications, including quarterly earnings releases from numerous companies, commonly reference EPS and year-over-year EPS growth. For companies that repurchase shares, an unaware investor would be under the impression that the company grew earnings at a faster rate than it actually did.

Another popular metric P/S (Price to Sales), is affected similarly:

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While all per-share ratios are affected, the issue does not stop there. Share repurchases fundamentally alter the balance sheet, and as a result, affect other ratios - Debt to Equity, Return on Assets & Return on Equity.

Debt to equity (D/E) - Assuming share repurchase are funded with cash, debt would remain the same, while equity is reduced. By reducing equity, the Debt-to-Equity ratio becomes larger, giving the appearance that the company has increased leverage. If the company actually funded the repurchase with debt, the ratio would become even larger.

Return on Assets (ROA) - By repurchasing shares with cash, the assets on the balance sheet are reduced, increasing the Return-on-Assets ratio.

Return on Equity (ROE) - When shares are repurchased, the equity on the balance sheet is reduced, increasing the Return-on-Equity Ratio.

No fundamentals were actually improved; however the company is now able to show a higher ROA & ROE. Again, year-to-year comparisons become a lot less meaningful and don't provide an accurate picture of the company's fundamentals. An investor making year-to-year comparisons may conclude the company is improving efficiency, with an increasing ROE & ROA; when in reality, that is not the case.

Conclusion

Share repurchases can be an effective way for companies to offer additional value to shareholders. Many large companies participate in share repurchasing programs, and I am not advocating against them. I believe there are many cases where they are appropriate and offer an effective way to increase shareholder value. Investors however must be aware of the affect share repurchases have on many commonly used financial ratios. Year-to-year comparisons of EPS, P/E, P/S, ROA & ROE, end up being positively biased, without any actual improvements to the underlying fundamentals. We would hope that companies are not participating in share repurchases merely to appear healthier with improved ratios; however, it may be a motive in some cases. Regardless, investors should be cautious when examining any per-share ratios for companies that participate in share buybacks. For meaningful year-to-year comparisons, investors should go directly to the financial statements, and examine the actual numbers, rather than rely on heavily published per-share ratios.

Source: How Share Repurchases Manipulate Fundamental Ratios