Most investors look for companies that distribute a portion of their earnings in the form of dividends. On the other hand, there are some investors, including the legendary Warren Buffett, who prefer share repurchases instead of dividends when the former are executed correctly. When a company repurchases its shares, it reduces the number of its remaining shares, thus increasing its earnings per share (EPS) and consequently its stock price.
According to Buffett, the great advantage of buybacks is that the investor essentially reinvests the whole distribution of the company on the stock without incurring a tax bill, whereas dividends incur a tax bill. Moreover, the buybacks confirm the management's confidence on the value of the stock. In addition, an important side benefit of the buybacks is the defensive nature of buybacks in a market correction - when a stock declines, the company can purchase a greater number of its shares, thus further increasing its EPS.
Companies with aggressive buybacks have greatly outperformed the market in most time horizons. An investor who looks for share buybacks can invest in the PowerShares Buyback Achievers Portfolio ETF (PKW), which tracks US companies that have repurchased at least 5% of their shares in the last 12 months. However, most investors prefer to select their own stocks. The big question for these investors is which buybacks are the most sustainable. If they cannot answer this question, they will be forced to switch repeatedly from stocks that terminate their buybacks to stocks that maintain them, which is time consuming and costly due to the increased commissions and the steep decline of stocks of companies that announce suspension of their buybacks.
Price vs. intrinsic value
According to Buffett, a company should repurchase its shares only if they trade below their intrinsic value. However, as the intrinsic value of a stock is difficult to determine, this criterion should be used only by the most experienced investors. For instance, Berkshire Hathaway (BRK.A) (BRK.B) purchases its own shares only when they trade below 120% of their book value.
Most investors make the mistake to select companies that have performed buybacks at an aggressive rate in the past and hence have greatly increased their EPS. However, for the aggressive rate to be sustained, the stock should have a low P/E (price to earnings) ratio. In fact, the P/E ratio of the stock determines the rate of buybacks the company can achieve if it allocates all its earnings into buybacks.
For instance, when a stock trades at P/E=10, the company can purchase 10% of its shares in a year. In the same way, when a stock trades at P/E=20, the company can purchase only 5% of its shares per year.
Of course a company may repurchase a greater number of its shares than the one based on P/E by borrowing money. This reveals us the other major determinant of the sustainability of the buybacks, which is the amount of net debt of the company. When a company has a low level of debt and its current assets greatly exceed its current liabilities (due in 12 months), it can easily borrow money, particularly at the current low interest rates, and thus increase its share buybacks. On the other hand, when a company has stretched its debt to the limits, its buyback capacity is limited by the P/E ratio of the stock.
Growing or constant earnings
The third (and last) factor that determines the sustainability of the share repurchases is the trend of the earnings (not EPS) of the company. If they increase or remain constant, then the company can sustain the rate of buybacks dictated by the P/E ratio. Otherwise, the rate of buybacks will be reduced unless the company increases its debt load.
Examples of sustainable share repurchases
In a previous article, I suggested that Apple should utilize its enormous cash hoard and purchase almost half of its shares in the next few years at the current low P/E of about 11. Fortunately, the management now seems to agree and has initiated a share buyback program of $50 B, which is more than sustainable and efficient thanks to the cash hoard of $163 B and the low P/E, respectively.
Exxon Mobil (XOM)
Exxon Mobil has consistently spent about $20 B every year to repurchase its shares, thus reducing its share count by about 5% every year. As Exxon trades at P/E=11 and carries a minimal amount of debt (equals about 2 years' earnings), it could repurchase even 9% of its shares every year but the company prefers to distribute a ~3% dividend as well. Therefore, its buyback rate can be easily sustained.
It is remarkable that a beneficial effect of Exxon's share buybacks is that it has greatly restricted the financial burden of the 30 consecutive dividend increases on the company.
Bed Bath & Beyond (BBBY)
Bed Bath & Beyond has purchased 15% of its shares in the last 3 years. As its stock trades at a P/E=16, its earnings increase almost every year and its debt level is minimum (it can be fully paid off with one year's income), the rate of buybacks is sustainable.
Nevertheless, its shareholders should not be completely satisfied because almost one-third of the buybacks end up as bonus to the management instead of the shareholders. More specifically, the company purchased about 9% of its shares in 2012 but the number of outstanding shares was reduced by only 6%.
My favorite example of the benefit of share repurchases is Torchmark, in which Berkshire has a 4.6% stake. Torchmark is an insurance company that has repurchased almost half of its shares in the last 9 years. Therefore, although its earnings rose only 20% in the last 9 years, its EPS more than doubled.
This company is the best example of the effectiveness of buybacks because it illustrates the exponentially increasing effect of buybacks when the number of existing shares has greatly diminished. To be more specific, if the company continues to allocate about $400 M per year on share repurchases, it will reduce its share count to about 1/5 in 10 years (depending on the share price), which will quintuple the stock price if the earnings remain constant. Thanks to the low P/E (12.5) and its consistent earnings, the company can readily sustain its past buyback rate. For more details, you can read my article on Torchmark.
Examples of unsustainable share repurchases
DirecTV has purchased half of its shares in the last 4 years (!), thus greatly rewarding its shareholders. This is an exceptionally aggressive buyback rate which has helped triple the stock from its bottom in the Great Recession. However, to achieve this, the company pronouncedly increased its debt load, which now stands at $20 B. As its current liabilities (due in the next 12 months) now equal its current assets, DirecTV will only be able to use this year's earnings to continue its buybacks and hence it will not be able to purchase more than 8% of its shares (P/E=12).
Even worse, the earnings of the company may decrease as the company may not renew the NFL Sunday Ticket and its credit default swaps markedly increased last month. Consequently, although the company utilized the record-low interest rates to reward its shareholders with buybacks in the last 4 years, it is not likely to sustain its past buyback rate.
Autozone has purchased 60% of its shares in the last 9 years. Therefore, although its earnings less than doubled during that period, its EPS more than quadrupled. As usual, the share price followed very closely the EPS and hence shareholders were greatly rewarded.
However, Autozone used a huge load of debt to achieve the above buyback rate and hence the current liabilities of the company now exceed its current assets by $650 M (!). Consequently, the company will use most of its annual earnings ($1 B) to pay its current liabilities and hence it is not expected to sustain its past rate of buybacks.