Why I Love Companies with Share Buybacks

1. INTRODUCTION

In this blog post, we will discuss the following topics:

• [1] What is a stock buyback and stock buyback program?
• [2] Why do companies engage in share buybacks?
• [3] Why I think share buybacks are great for your investments
• [4] What happens to our example Builders Firstsource

[1] What is a stock buyback and stock buyback program?

A share buyback program, also known as a share repurchase program, is a strategy that companies use to buy back their own shares from the market. This can be done through open market purchases, tender offers, or other methods. The goal of a share buyback program is to reduce the number of outstanding shares, which can increase the value of remaining shares and improve the company’s financial metrics. Companies may choose to buy back shares for a variety of reasons, including to boost their stock price, to return excess cash to shareholders, or to improve their financial ratios. Share buyback programs are typically approved by the company’s board of directors and are subject to certain legal and regulatory requirements. Investors tend to view share buyback programs positively, as it can signal that the company is financially healthy and confident in its future prospects. Builders Firstsource, for example, has recently increased their share buyback program by $1B.

This means nothing more and nothing less than that they are using $1B of their cash to buy their own shares in the market for the duration of the share buyback program. As of today December 8th 2022, Builders Firstsource has the following statistics as shown below. We will get to the fundamentals and the calculations later in the blog post.

[2] Why do companies engage in share buybacks?

Companies engage in share buybacks for a variety of reasons, including:

1. To boost their stock price. By buying back shares, companies can reduce the number of outstanding shares, which can increase the value of remaining shares and boost the stock price. This can be particularly beneficial if the company’s stock is undervalued or if the market is volatile.
2. To return excess cash to shareholders. If a company has excess cash that it does not need for operations or investments, it may choose to buy back shares as a way to return that cash to shareholders. This can be seen as a form of dividend, as shareholders receive cash for their shares.
3. To improve their financial ratios. Buying back shares can improve a company’s financial metrics, such as earnings per share (EPS) and return on equity (ROE), which can make the stock more attractive to investors.
4. To reduce the number of outstanding shares. Reducing the number of outstanding shares can make the company more attractive to potential acquirers, leading to potential acquisition offers and a higher stock price.

Overall, share buybacks can be seen as a sign that the company is financially healthy and confident in its future prospects, and investors tend to respond positively to this news.

[3] Why I think stock buybacks are great for your investments

The reasons why stock buybacks are great for your stock investments are basically the same as why companies engage in their share buybacks; they are great for investors. But why? Lets make two important points first:

• The legendary investor Warren Buffett thinks that companies shouldn’t assign their investors’ cash to social causes and should instead focus on what would most benefit the shareholders. I strongly agree with Buffet here: companies should try to focus on their shareholders and focus on generating a high return on their invested capital. This can be done by investing in profitable expansion of the business and when there are no more highly profitable investments to be found for the business, the business can invest in itself by buying its own shares at a discount to what management thinks is a fair value for the stock.
• Peter Lynch has correctly said that there is a high correlation between earnings and share prices. That is because stocks are no lottery tickets, there are small parts of businesses. If the business performs strongly so will the shares of that business. That is why investors use earnings per share (EPS) to evaluate the profitability of a company. EPS is calculated by dividing a company’s net income by the number of outstanding shares. This metric provides a measure of the amount of profit generated by each share of stock, and is often used to compare the profitability of different companies or to assess the performance of a company over time.

In conclusion, there is additional demand for the shares of the company. There are eventually less shares outstanding. The company can invest in itself and therefore receive great returns if their investment thesis is true (since management are insiders they tend to know best). Share buybacks can be a signal to the market that the company (and management) thinks the shares are highly undervalued and also create additional demand from other investors.

[4] What happens to our example Builders Firstsource

So Builders Firstsource has recently announced that ”its Board of Directors approved an increase to the Company’s existing stock repurchase plan in the amount of $1 billion, for a total of approximately $1.5 billion inclusive of the remaining outstanding authorization at the end of the third quarter of 2022.” With marketcap (share price x total shares outstanding) of $9.739B this means that at the current share price they are buying back ($1B / $9.739B) = 10.26% of their outstanding shares with the new buyback program. Practically, this means 2 things:

• if their total net profit would stay constant, their earnings per share would be 10.26% higher since there would be 10.26% less shares to divide the net profit with
• if their total net profit would decline by 10.26% in the coming period, their earnings per share would stay constant. You have basically provided yourself with a recession cushion.

So lets dive a little deeper and see if Builders Firstsource is trying to trap their investors by virtue signalling or if they are serious about their share buyback program:

When analyzing their balance sheet on a quarterly basis, we notice that there shares outstanding (share issued) are constantly declining at a rapid rate. In 1 year time, Builders Firstsource has decreased their shares by 24.09% (or increased their EPS by 24.09% with buybacks alone!) We also notice on their yearly cash flow statement that they have spend $3B in the past year buying back their own shares and had free cash flow of $3B. In fact, Builders Firstsource is a company with a relative high level of debt and high level of free cash flows. I will go into detail why that also is a bullish signal in the current market due to the increases in interest rates. But for this blog, lets stick to the buyback program.

As a last thought provoking exercise, lets see what various increases in share buybacks do to the EPS of Builders Firstsource, as shown in the table below.

We notice that in 3 years time, the EPS could increase by 33% if the company is able to buyback their shares at 10% of the shares outstanding for the 3 year period. Ofcourse, as there are less shares outstanding and more demand, the share price will go up and eventually it will no longer be attractive for the company to be buying back their own shares instead of investing in their business, but the table is provided for illustration purposes only.

2. CONCLUSION

Share buybacks alone should not be a reason for you as investors to automatically go out and buy the shares of the specific company but rather be part of your due dilligence on the business fundamentals of your investments. Just as with all investments, the future is uncertain. Shares for highly unprofitable businesses that are losing money and can never keep up with the pace of their buybacks should be avoided. Shares of companies that pile (into more) debt to increase their share price in the short term should be avoided. Companies that increase their share price in the short-term by buybacks just to make sure management is able to cash in on their options should be avoided. It is not the fact that a buyback program is conducted that is a positive sign for the business, but it is a positive sign for a already positive business with a capable and motivated management team that is focused on rewarding their shareholders. The increase in EPS and ROE by the buybacks can be reversed by a deteriorating business (environment) and can only be used as a cushion against lower net income is the free cash flows of the company remain solid.

The true gems can be found in business that are (highly) in debt for which the market value of the debt is down significantly due to the recent increases in interest rates but have strong free cash flows that provide the business the opportunity to pay off their debt on a discount. Better buy the stock instead, says Benjamin Graham father of value investing. More on these type of companies in our next blog.

DISCLAIMER

Eurykleia Investments is not a registered investment, legal or tax advisor or a broker/dealer. All investment/ financial opinions expressed by Eurykleia Investments are from the personal research and experience of the owner of the site and are intended as educational material. Although best efforts are made to ensure that the all information is accurate and up to date, occassionally unintended error and misprints may occur.