What is a share buyback, and should you avoid investing in companies that often buy back their shares?
Hi, I'm Henrikh. In this article, I'll introduce you to share buyback programs shortly and will share my ideas if it is worth investing in those companies or not. Definitely, there are companies that do well buying back their own shares, and oppositely there are companies that damage their business buying back their own shares. Today we’ll go over those elements to identify if a company is doing well or not.
OK, let’s start.
Firstly let’s shortly understand what a share buyback program is. It is when a company buys its own shares, and when they buy them, the X amount of shares are canceled. Like if a company has 5 shares, each share represents a 20% portion of the company, and the company buys 1 share back, that means 1 share is canceled, and after that, there are only 4 shares outstanding for 100% of the company, and each of those 4 shares automatically becomes more valuable on the hand of shareholders as each share has a bigger proportion of the company after the share buyback program is executed. Each share represents a 25% portion of the company. So the main point is that shares become more valuable as a portion of a company, but the company’s equity decreases as they spend money to buy those shares in the market. So the company becomes smaller. So every coin has 2 sides. When particular shares are canceled, the shareholders own a bigger proportion of something that now has less value than before the share buyback program was executed. So the question is which one is more valuable: to have a small portion of something big or to have a bigger portion of something smaller? So to identify if a company is doing well or not when buying back its own shares, we must focus on 2 main things, “the ability” and “profitability.”
Let’s start with the “ability.” The main question here is if the company has enough ability to spend that much cash and has enough liquidity and a healthy balance sheet to afford a share buyback.
To know the answer to those questions, you must look at the balance sheet. If the company has loads of debt or has a low current ratio, or has limited cash, but still runs a share buyback program, that’s a big red flag for a company. Ideally, a company should run a share buyback program when it has a healthy balance sheet, meaning a lot of cash, low debt to equity ratio, or even no debt and must have a current ratio being higher than 1. And even in those cases, good companies think it is better to spend their money investing in new ideas than share buybacks. So if they don’t know where to invest their money and they don’t want the money to sleep on their balance, only then it’s a good idea to run a share buyback program. Because it’s just another way of paying investors like dividends. But that’s good only when they have enough cash for a rainy day, and they don’t know what to do with that extra liquidity. Only having cheap financing should not refer to a share buyback program.
You may be surprised why a company should start a share buyback program if they don’t have a healthy balance sheet. There are many reasons for it. I will just name a few important ones.
Reason A - They do it because it’s fashionable and they want to show that everything is OK in the company.
Reason B - The management or the CEO has stock options as compensation, and they will personally benefit financially from the rising stock price.
Reason C - They want to boost the per share data to show a growing company to attract new investors.
And Reason D - the management is stupid, that’s it.
So you must run away from those companies that don’t know what they are doing, or they act without taking care of the business and shareholders in the long run. Unfortunately, there are many companies in the market that use every ounce of their balance sheet to buy back shares at times when they shouldn’t do that. We had a typical example in the airline industry when CEOs borrowed a lot of money to buy their company shares back while having many problems with their balance sheet. They boosted the stock prices, but the business got a lot of problems in the future, so when the economic shutdown started they only needed the government to bailout them because their current ratio metric was less than 0.5 and they couldn’t cover their payables as they didn’t have enough liquidity. But only a few months sooner, they were running share buyback programs to boost the share price. And that’s why later the government was against share buyback programs for the companies they bailout. They just don’t want the idiots to damage the businesses further. And oppositely, we have many good examples like Apple, Facebook, and other companies that really do well by running a share buyback program. They have enough excess cash and healthy businesses to afford themselves a share buyback program.
Ok, let’s say a company we want to invest in has a share buyback program and a healthy balance sheet. But that’s still not enough to judge if the company is doing well or not. We must understand the second important part of this process, which is profitability.
So the main question we must focus on is if the company is doing a profitable deal by buying the shares back. Are shares trading cheap in the market or is the company overpaying for those shares? If the company is overpaying for the shares, then it’s not talking well about the management. And if shares are trading cheaper than their true intrinsic value, then the company is doing well buying back their own shares as a share buyback program is a typical investment. As Warren Buffett explains, there is no big difference if you invest in buying your own shares or another company's shares. If you are paying less than what it’s worth, then you are making a good investment. And oppositely, if you are overpaying, then you are doing it wrongly. Another thing Warren Buffett said is that if a company finds its stock selling below the true intrinsic value, they will even make a big mistake if they don’t buy back their shares.
So to understand if the shares are being sold in the market cheaper than their true intrinsic value, we must first value the share price ourselves.
What is a share buyback, and should you avoid investing in companies that often buy back their shares?
Hi, I'm Henrikh. In this article, I'll introduce you to share buyback programs shortly and will share my ideas if it is worth investing in those companies or not. Definitely, there are companies that do well buying back their own shares, and oppositely there are companies that damage their business buying back their own shares. Today we’ll go over those elements to identify if a company is doing well or not.
OK, let’s start.
Firstly let’s shortly understand what a share buyback program is. It is when a company buys its own shares, and when they buy them, the X amount of shares are canceled. Like if a company has 5 shares, each share represents a 20% portion of the company, and the company buys 1 share back, that means 1 share is canceled, and after that, there are only 4 shares outstanding for 100% of the company, and each of those 4 shares automatically becomes more valuable on the hand of shareholders as each share has a bigger proportion of the company after the share buyback program is executed. Each share represents a 25% portion of the company. So the main point is that shares become more valuable as a portion of a company, but the company’s equity decreases as they spend money to buy those shares in the market. So the company becomes smaller. So every coin has 2 sides. When particular shares are canceled, the shareholders own a bigger proportion of something that now has less value than before the share buyback program was executed. So the question is which one is more valuable: to have a small portion of something big or to have a bigger portion of something smaller? So to identify if a company is doing well or not when buying back its own shares, we must focus on 2 main things, “the ability” and “profitability.”
Let’s start with the “ability.” The main question here is if the company has enough ability to spend that much cash and has enough liquidity and a healthy balance sheet to afford a share buyback.
To know the answer to those questions, you must look at the balance sheet. If the company has loads of debt or has a low current ratio, or has limited cash, but still runs a share buyback program, that’s a big red flag for a company. Ideally, a company should run a share buyback program when it has a healthy balance sheet, meaning a lot of cash, low debt to equity ratio, or even no debt and must have a current ratio being higher than 1. And even in those cases, good companies think it is better to spend their money investing in new ideas than share buybacks. So if they don’t know where to invest their money and they don’t want the money to sleep on their balance, only then it’s a good idea to run a share buyback program. Because it’s just another way of paying investors like dividends. But that’s good only when they have enough cash for a rainy day, and they don’t know what to do with that extra liquidity. Only having cheap financing should not refer to a share buyback program.
You may be surprised why a company should start a share buyback program if they don’t have a healthy balance sheet. There are many reasons for it. I will just name a few important ones.
Reason A - They do it because it’s fashionable and they want to show that everything is OK in the company.
Reason B - The management or the CEO has stock options as compensation, and they will personally benefit financially from the rising stock price.
Reason C - They want to boost the per share data to show a growing company to attract new investors.
And Reason D - the management is stupid, that’s it.
So you must run away from those companies that don’t know what they are doing, or they act without taking care of the business and shareholders in the long run. Unfortunately, there are many companies in the market that use every ounce of their balance sheet to buy back shares at times when they shouldn’t do that. We had a typical example in the airline industry when CEOs borrowed a lot of money to buy their company shares back while having many problems with their balance sheet. They boosted the stock prices, but the business got a lot of problems in the future, so when the economic shutdown started they only needed the government to bailout them because their current ratio metric was less than 0.5 and they couldn’t cover their payables as they didn’t have enough liquidity. But only a few months sooner, they were running share buyback programs to boost the share price. And that’s why later the government was against share buyback programs for the companies they bailout. They just don’t want the idiots to damage the businesses further. And oppositely, we have many good examples like Apple, Facebook, and other companies that really do well by running a share buyback program. They have enough excess cash and healthy businesses to afford themselves a share buyback program.
Ok, let’s say a company we want to invest in has a share buyback program and a healthy balance sheet. But that’s still not enough to judge if the company is doing well or not. We must understand the second important part of this process, which is profitability.
So the main question we must focus on is if the company is doing a profitable deal by buying the shares back. Are shares trading cheap in the market or is the company overpaying for those shares? If the company is overpaying for the shares, then it’s not talking well about the management. And if shares are trading cheaper than their true intrinsic value, then the company is doing well buying back their own shares as a share buyback program is a typical investment. As Warren Buffett explains, there is no big difference if you invest in buying your own shares or another company's shares. If you are paying less than what it’s worth, then you are making a good investment. And oppositely, if you are overpaying, then you are doing it wrongly. Another thing Warren Buffett said is that if a company finds its stock selling below the true intrinsic value, they will even make a big mistake if they don’t buy back their shares.
So to understand if the shares are being sold in the market cheaper than their true intrinsic value, we must first value the share price ourselves.
