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This is the first installment in a series of articles that will provide detailed analyses of companies that are serious about buying back stock and delivering value to shareholders. In this series, I will explain why I prefer buybacks to dividends and why buybacks are so effective for companies that also pay dividends.

This first article will lay the groundwork: explaining what a buyback is and why it is such a great way to deliver value to shareholders.

What Is a Buyback

A buyback, or share repurchase, is pretty self-explanatory. It is a board-approved repurchase of a company's own stock. Typically, the board of directors approves a specified amount of company dollars to be spent buying back stock, not any specific number of shares. The approval also usually has a time limit -- the company will usually have a year or two to execute the buybacks, after which it will need to seek board approval again.

Why a Buyback Works

A stock buyback is extremely effective for several reasons:

  1. More Effective Than a Dividend: Have you ever wondered why Berkshire Hathaway (BRK.A, BRK.B), a company that fits the dividend-paying mold, doesn't pay a dividend? It's because Warren Buffett recognizes that there are better methods of giving back to shareholders. A buyback delivers value to shareholders like a dividend without the capital gains taxes that a dividend is prone to. When a company pays out a dividend to shareholders, the shareholders must declare the dividends on their taxes and pay capital gains taxes on the money. With a buyback, this capital gains tax is completely avoided, making the buyback 15%-20% more effective than a dividend.
  2. Saves Money: A buyback allows a dividend-paying company to save money. Dividend-paying companies typically declare a specific dollar amount to be paid out per share to shareholders every quarter. When a company buys back stock, it decreases the number of shares outstanding but has no effect on how much the company pays out in dividends. For example, if a company paid out $2 per share every quarter to shareholders in dividends and had 1 million shares outstanding, the company would be paying $2 million to shareholders every quarter. If the company were then to buy back 100,000 shares, it would have 900,000 shares outstanding left and only be paying out $1.8 million every quarter. That's $200,000 more that the company has to reinvest in itself every quarter. This saved "dividend expense" is saved perpetually. The company will have $200,000 more to reinvest in itself every quarter forever.
  3. Price Support: The buyback provides floor support on stock price. When a company buys back its own stock, it typically does so in the open market. In the stock market, a stock is prone to depreciation when more shares are being sold then are being bought. Since a company has discretion over when to execute buybacks, companies will typically buy back shares when other investors are selling the most. This prevents price depreciation.
  4. Vote of Confidence: The buyback is a vote of confidence to prospective investors. Insider ownership is one of the most important factors in an investment decision for many people. We like to buy when insiders are buying and sell when insiders are selling. We do so because we believe insiders have a better understanding of a company's prospects than we ever could. Most investors apply this to entire companies as well. If a company is buying back its own stock, investors are encouraged to follow suit.
  5. Increases EPS and Stock Price: There are two components to stock price: earnings and multiple. A company has very little control over what multiple the market assigns to it, but it can control the earnings end of things. Earnings are calculated by dividing net income by shares outstanding. When a company buys back shares, net income is unaffected while the number of shares outstanding is decreased. Algebra tells us that a constant divided by a smaller denominator will always produce a greater result. If Company A has a net income of $1 million and 1 million shares outstanding, EPS is $1. If Company A buys back 100,000 shares, EPS is now $1.11. The market multiple isn't really affected by the buyback, so if the market assigns a multiple of 15 to the shares of Company A, then in the first scenario the shares would trade at $15 -- whereas with the buybacks, the shares would trade at $16.65. The buyback has generated 11% earnings growth and price appreciation.

Better Fundamentals for Yield Hunters

The term "yield hunter" has become commonplace for investors who scour the market for stocks with high dividend yields. What most of these investors are really after, though, are companies that deliver value to shareholders. Since a company can do so through dividends or buybacks, I think it is more appropriate to include both in yield calculations. In this series, I will refer to this fundamental ratio as total yield and will calculate it as follows:

(Estimated Annualized Buyback Dollars / Market Cap) + Dividend Yield

I will also calculate dividend expense saved for dividend-paying companies to show how much more money the company will have to reinvest as a result of the buybacks, and calculate it as follows:

(Estimated Shares to Be Bought Back * Annual Dividends Per Share)

I will also calculate total payout ratio to show how much of earnings a company is actually returning to shareholders, and calculate it as follows:

(Dividends Paid + Annualized Buyback Dollars) / Net Income

Conclusion

I hope this series will shed light on the beauty of stock buybacks and provide investors with several companies committed to the practice.

Source: The Buyback Kings, Part 1: Buy Companies That Buy Themselves