A buyback is when a company buys back its own stock. As a company buys back shares, its future earnings, dividends and assets concentrate in the hands of an ever-shrinking shareholder base.
These companies become more valuable by losing shareholders.
Warren Buffett wrote in his 2000 letter to shareholders:
There is only one combination of facts that makes it advisable for a company to repurchase its shares:
"First, the company has available funds - cash plus sensible borrowing capacity - beyond the near-term needs of the business, and, second, finds its stock selling in the market below its intrinsic value, conservatively calculated."
If those two requirements are met, Buffett is an enthusiastic supporter of stock buybacks. When done right, buybacks can accelerate the compounding of returns. When you find a company that drives its shares outstanding lower over time and seems to have a knack for buying at good prices, you should take a deeper look.
In a slow to no-growth economy, this tactic is becoming a more important driver of earnings-per-share growth. But you have to actually shrink the number of shares outstanding.
Since 1998 to 2015, the 500 largest US companies have bought back about one-quarter of their shares in dollar value,, yet the actual shares outstanding grew. This is because they hand out the shares in lavish incentive packages to greedy executives.
When evaluating share buybacks, make sure to look at actual shares outstanding. Relying on company news releases alone can be misleading.
Companies also buy back shares
- to support employee incentive programs or
- to accumulate shares for an acquisition.
Such repurchases may be okay but aren't the kind of repurchases that increase return on equity for remaining owners.
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