Sometimes a company has surplus funds that it does not need for its operations. It can use those funds to expand its operations (eg buy new businesses) or it can distribute them to stockholders. One way of distributing funds to shareholders is to have a share buy back, click wherein the company buys back some of its shares from existing stockholders.
Company A has 100 shares issued and makes a profit of $50. This means a shareholder is getting a return of 50 cents a share ($50/100). This is the Earnings per Share or EPS. If the share sells on the stock exchange for 15 times its EPS, help a share has a value of $7.50.
Suppose that the company buy back 25 shares. A shareholder who retains their shares now earns 67 cents ($50/75) on each share held. If the share sells on the stock exchange for 15 times its EPS, a share has a value of $10.
Warren Buffett likes companies that buy back their shares if they do so for the right reasons, and if they pay less than the intrinsic value of the share. . A share buy back that is designed simply to inflate or support the value of the shares is not a good reason.
Warren Buffett on buybacks
In 1999, Warren Buffett said this:
Now, repurchases are all the rage, but are all too often made for an unstated and, in our view, ignoble reason, to pump up or support the stock price. The shareholder who chooses to sell today, of course, is benefited by any buyer, whatever his origin or motives. But the continuing shareholder is penalised by repurchases above intrinsic value. Buying dollar bills for $1.10 is not good business for those who stick around.
So, according to Warren Buffett, a company can add value to its shares by buying some of them back:
- where it has surplus funds;
- where it can buy them back at a price below intrinsic value.
Warren Buffett has said on several occasions, in relation to Berkshire Hathaway, that the company will never buy back shares merely to bolster the share price or to stop a fall in the price.