What are share buybacks?

A share buyback is where a company buys its own shares on the stock exchange and cancels them to reduce the total number of shares in issue.

The justification for share buybacks can seem very powerful at first glance. By reducing the number of shares in issue a company can spread its profit across a lower number of shares and increase earnings per share (EPS). This might then allow it to pay a bigger dividend per share as well.

As lots of people value shares using price to earnings (PE) ratios, higher EPS can lead to a higher share price too. This is because the higher EPS after a buyback can lower a PE ratio and make the shares look cheaper than they were before. This attracts buyers who can push the share price up. As some investors prefer capital gains to income from a tax point of view (because they are taxed more favourably), surely share buybacks are a win-win for everyone? Not so fast. A higher EPS does not always mean that a company has become more valuable.

As I said just now, share buybacks have been growing in popularity in recent years and have been seen as a major reason for why shares have performed well since the financial crisis. Instead of using their cash flows to invest in new projects to increase their profits, many companies have been buying their own shares instead. The share prices of many companies that have done this have gone up a lot in the short run, but time will tell if this is money that has really been spent well.

Don't be fooled by share buyback maths

The cheerleaders of share buybacks tend to overlook one crucial and important point - the price paid for the shares when they are bought back. Remember, all investment is about getting a decent return on your money. Increasing EPS by buying back shares doesn't necessarily mean that you are doing this.

Let me show you how a share buyback works out in practice by looking at a fictional company called Bob's Book Store.

Bob has built up a very successful business over the years. He is making a very impressive £100m of trading profits every year but stiff competition means that this number is unlikely to change much. The stock market is in buoyant mood though and has given his shares a very punchy valuation of £1.6 billion or 20 times earnings (a PE ratio of 20) despite the low or non-existent growth prospects.

Bob needs to keep his shareholders happy. His advisors suggest buying back 10% of the existing shares in issue (in this case 100 million of them) so that earnings per share (EPS) can keep growing. So, instead of paying a dividend, Bob decides to use £160m (the equivalent of the next two years' post tax profits) to buy back shares at the price of 160p each instead. Look at the table below and the explanation underneath.

Using spare cash to buy back shares

Bob's shares are priced at 160p and there are 1000 million shares in issue giving Bob's Book Stores a market capitalisation of £1,600m.

Bob has £160m available cash which means he can buy 10% of his company's shares.

His post-tax profit of £80m is now spread across 900m shares giving an EPS of 8.9p - an 11.11% increase.

Company executives such as Bob like share buybacks because more often than not their bonuses are linked to higher EPS. They can be useful for offsetting new shares that have been issued for bonuses and share options. Company stockbrokers also encourage them because they can charge commission on all the shares bought back.

But lots of Bob's shareholders are not happy. It turns out that the shares were not worth 160p at the time. They were overvalued at this price because of their low growth prospects. They are now trading at 80p each - equivalent to a PE ratio of 9 on the higher EPS. The £160m spent on a share buyback has been a huge waste of money. The lesson here is this:

Share buybacks only make shareholders better off if the price paid for the shares is less than the company is actually worth

So what Bob was doing was paying 160p per share for a business that was only really worth 80p per share (8p x PE of 10 before the buyback). Look at the table below. You can see that, in doing so, he reduced the true underlying value of the business to just over 71p. If he had paid 75p then he would have increased the value of the business. The effect on EPS is irrelevant. By paying too much, Bob has destroyed a large chunk of shareholder value just as many company managements do in the real world.

Spending cash on buying back shares reduces the total value of the business (because you have less cash). Value per share only goes up if the business value shrinks by less than the reduction in the number of shares. You can only do this by buying back shares for less than they are worth.

Getting back to Marks & Spencer, its buyback will only make its shareholders better off if the current share price of 580p is less than the real value of the business. The trouble for you and me is that there's no way of accurately knowing this. Fortunately, there is another, more practical way to work out if a share buyback could be good for shareholders or not.

Special dividends could make a lot more sense than buybacks

I like this ERR test and think it is an extremely useful way of looking at the merits of a share buyback. That said, just because a company is getting a reasonable return it doesn't necessarily mean that a buyback is making shareholders better off. They can still be paying too much.

For example, existing assets might earn returns of 20% (look at return ratios to check this out) and so a buyback giving 8% doesn't look too good. Have a look at the valuation the buyback is taking place at. Is the PE ratio a lot higher than the share's historical average?

That's why giving the money back to shareholders with special, one-off dividends might be a more sensible thing to do. They are less likely to be confused and more likely to be better off. It is encouraging to see that companies such as Next and many house builders and insurance companies are doing this.

Buyback calculator

We've included a handy buyback calculator below. To edit the values, simply double-click on the relevant cell and enter a new figure.

You can also download or view a full-size version of this buyback calculator via the ribbon (the black, horizontal bar directly below the spreadsheet).