Share buybacks can be a boost to corporate earnings per share (EPS), but a drag on book value growth. Many value investors use the price-to-book ratio to find undervalued stocks. Buybacks, also called share repurchases, can warp the results, making price-to-book a useless measurement for valuing many stocks. The companies that regularly reduce their share count through repurchases may appear overvalued on a book value basis.

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This article will examine why buybacks have a favorable result for EPS growth but typically lower the book value per share, slowing the growth of this asset-based measure. (For background reading on the different types of buybacks, check out A Breakdown Of Stock Buybacks.)

What Does A Buyback Look Like?
Book value, also called shareholders' equity, is defined as a company's total assets minus total liabilities (i.e. debt). Book value per share is the total book value divided by the number of shares outstanding. Let's look at this example that shows how buybacks affect earnings per share and book value per share of a super-sized corporation doing a large one-time buyback. (To learn how to find these numbers on a company's financial statements, read our tutorial on Financial Statements.)

Example - How buybacks affect EPS and book value per share

XYZ Corporation: pre-buyback

  1. Total assets $300 billion - Total liabilities $150 billion
    Book value = $150 billion
  2. Book value $150 billion / Shares outstanding 1 billion
    Book value per share = $150
  3. Annual earnings $20 billion / Shares outstanding 1 billion
    Earnings per share = $20
  4. EPS $20 / Book value $150 per share
    Return on equity = 13.3%

Assume XYZ\'s stock is trading for $200 per share and XYZ buys back half of all its shares (500 million in all), or a total of $100 billion of shares. In the real world this would take place over a number of years at various prices, but for illustration purposes let\'s assume it all happened at once.
XYZ Corporation: post-buyback
Note: $100 billion of cash assets was spent to buy 500 million shares at $200 per share.

  1. Total assets $200 billion - Total liabilities $150 billion
    Book value = $50 billion
  2. Book value $50 billion / Shares post-buyback 0.50 billion
    Book value per share = $100 per share
  3. Annual earnings $20 billion / Shares post-buyback 0.5 billion
    Earnings per share = $40 per share
  4. EPS $40 per share / Book value $100 per share
    Return on equity = 40.0%

Notice that when the shares are repurchased above the current book value per share, it lowers the book value per share. If the stock was trading below book value, which is rare, the company could have raised its book value per share through a buyback.

There are several ways the buyback could show up on a corporate balance sheet, depending on several factors, but to keep it simple let's assume XYZ repurchased the shares with cash on hand, and then retired the shares. It's as if they burned the shares - never to be issued again. This results in a decrease in cash assets and therefore a decrease in shareholders' equity on the balance sheet, with no corresponding gain in other assets.

There are other, more complicated ways a company could handle the reporting of the buyback, such as issuing debt and holding the repurchased shares as treasury stock, but to keep it simple, let's stay with this basic example.

How Should You Interpret Buyback Results?
As you can see in this example, there is a major distortion of book value per share due to a major share repurchase done above the current book value per share number. Buybacks improved the EPS from $20 to $40, but lowered book value per share from $150 to $100. Also, notice that the return on equity (ROE) measurement goes from a rather normal 13.3% to an astounding 40%. ROE numbers can make a normal business look extraordinarily good, but should be viewed as an accounting abnormality when a major buyback occurs. (To learn how to spot a wayward return, read Keep Your Eyes On The ROE.)

How Do Buybacks Impact Financials?
Dollar Tree (Nasdaq:DLTR) is a company that has regularly done share buybacks. Let's examine what these buybacks have done to its financial ratios.

In 2003, Dollar Tree Stores earned $177.6 million. In 2007, this number grew to $201.3 million, an increase of 13.3%. During this same period, Dollar Tree's EPS grew to $2.09 from $1.54, an increase of 35%. What a difference! How did Dollar Tree make that happen? It did this through the financial magic of share buybacks. Now let's look at the cause of these strange results.

Dollar Tree's share count went from 114 million to about 90 million shares through share buybacks, a decrease of 21%. While EPS grew superbly from these buybacks, book value did not fare so well. It only grew $2.35, or 26%, from $8.90 per share to $11.25 per share, while the total EPS that Dollar Tree earned was $7.06. (To learn more about how to calculate EPS and book values, check out our tutorial on Fundamental Analysis.)

It's important to remember that each dollar of earnings does not always add to book value, although most of it should - in theory. This assumes no
dividends are being paid, which is the case with Dollar Tree. Dollar Tree's earnings were generally used to repurchase shares each year along with normal business expansion costs.

A few of the companies that repurchase shares on a regular basis include IBM, Wal-Mart, ExxonMobil, Coca-Cola and McDonald's. Note to CEOs: The long-term performance of the group of companies mentioned should be an example to other corporate executives of the benefits of stock buybacks. It seems that the better the business, the better idea it is to consistently repurchase shares at reasonable prices. If you run a poor business, then perhaps you're better off buying into better businesses.

Bottom Line
If you use price-to-book ratio as a measure of value, then you need to be careful if a company has been buying back stock. How can you tell if this has happened? Look at the company's total share count over successive years.

Most software-based stock screeners can't back out the per-share effect from stock buybacks, and therefore can only be used as a starting place to find promising investment candidates. The best solution for the investor is to look at growth in EPS and ROE, as well as price-to-book value, in the light of any artificial effects from buybacks. This means manually backing out the effects of any buybacks, which must be done one company at a time, resulting in extra time that you, the investor, must spend surveying possible investment candidates.