The Impact of Share Repurchases on Financial Accounting

A share repurchase or buyback is when a publicly traded company purchases its own shares in the marketplace. Along with dividends, share repurchases are a way that a company may return cash to its shareholders. When a company buys back shares, it's generally a positive sign because it means that the company believes its stock is undervalued and is confident about its future earnings.

Many of the best companies strive to reward their shareholders through consistent dividend increases and regular share buybacks. A share repurchase is also known as a float shrink because it reduces the number of a company’s freely trading shares or float.

Key Takeaways

  • A share repurchase, or buyback, refers to a company purchasing its own shares in the marketplace.
  • When a company buys back its shares, it usually means that a firm is confident about its future earnings growth.
  • Profitability measures like earnings per share (EPS) usually experience a huge impact from a share repurchase.
  • Share repurchases can have a significant positive impact on an investor’s portfolio.
  • Because share repurchases' value depends on the stock's future price, buybacks come with more uncertainty than dividends.

The Impact on Earnings Per Share (EPS)

Because a share repurchase reduces a company’s outstanding shares, we may see its biggest impact in per-share measures of profitability and cash flow such as earnings per share (EPS) and cash flow per share (CFPS). Assuming that the price-earnings (P/E) multiple at which the stock trades is unchanged, the buyback should eventually result in a higher share price.

As an example, consider the hypothetical company, Birdbaths and Beyond (BB), which had 100 million shares outstanding at the beginning of a given year. The stock was trading at $10, giving BB a market capitalization (market cap) of $1 billion. The company had net income of $50 million or EPS of $0.50 ($50 million ÷ 100 million shares outstanding) in the preceding 12 months, which means that the stock was trading at a P/E multiple of 20x (i.e., $10 ÷ $0.50).

Assume that BB also had excess cash of $100 million at the start of the year, which the company deployed in a share-repurchase program over the next 12 months. So at the end of the year, BB would have 90 million shares outstanding. For simplicity, we have assumed here that all the shares were repurchased at an average cost of $10 each, which means that the company repurchased and canceled a total of 10 million shares.

Suppose BB earned $50 million in this year as well; its EPS would then be about $0.56 ($50 million ÷ 90 million shares). If the stock continues to trade at a P/E multiple of 20x, the share price would now be $11.20. The 12% stock appreciation has been entirely driven by the EPS increase, thanks to the reduction in BB’s outstanding shares.


The Impact Of Share Repurchases

Stock Repurchases Drive Value for Shareholders

We've used a couple of simplifications here. First, EPS calculations use a weighted average of the shares outstanding over a period of time, rather than just the number of shares outstanding at a particular point. Second, the average price at which the shares are repurchased may vary significantly from the shares' actual market price.

In the example above, buying back 10% of BB’s outstanding shares would quite possibly have driven up its stock price, which means that the company would end up buying back less than the 10 million shares we have assumed for its $100 million outlay.

Companies that consistently buy back their shares can grow EPS at a substantially faster rate than would be possible through operational improvements alone.

These simplifications understate the magnified effect that consistent repurchases have on shareholder value. This rapid EPS growth is often recognized by investors, who may be willing to pay a premium for such stocks—which in turn results in their P/E multiple expanding over time.

Further, companies that generate the free cash flow (FCF) required to steadily buy back their shares often have the dominant market share and pricing power required to boost the bottom line.

Going back to the BB example, assume that the company's P/E multiple rose to 21x (from 20x), while net income grew to $53 million (from $50 million). After the buyback, BB’s stock would be trading at about $12.40 (i.e., 21 x EPS of $0.59, based on 90 million shares outstanding) at year-end, an increase of 24% from its price at the beginning of the year.

How a Share Repurchase Affects Financial Statements

A share repurchase has an obvious effect on a company’s income statement, as it reduces outstanding shares, but share repurchases can also affect other financial statements. However, note that buybacks do not impact the income statement line items (i.e., it is not recorded as an expense), only the published EPS figure reported beneath the net income.

On the balance sheet, a share repurchase would reduce the company’s cash holdings—and consequently its total asset base—by the amount of cash expended in the buyback. The buyback will simultaneously shrink shareholders' equity on the liabilities side by the same amount. As a result, performance metrics such as return on assets (ROA) and return on equity (ROE) typically improve subsequent to a share buyback.

Companies generally specify the amount spent on share repurchases in their quarterly earnings reports. You also may get the amount spent on share buybacks from the statement of cash flows in the financing activities section, and from the statement of changes in equity or statement of retained earnings.

A Share Buyback's Impact on Portfolios

Share repurchases can have a significant positive impact on an investor’s portfolio. For proof, one only has to look at the S&P 500 Buyback Index, which measures the performance of the 100 companies in the index with the highest buyback ratio—calculated as the amount spent on buybacks in the past 12 months as a percentage of the company’s market cap. Since its inception in January 1994, the S&P 500 Buyback Index returned 13.29% annually, compared with gains of 10.31% and 8.96% from the S&P 500 High Dividend Index and S&P 500, respectively.

What accounts for this degree of outperformance? As with a dividend increase, a share repurchase indicates that a company is confident in its future prospects. Unlike a dividend hike, a buyback signals that the company believes its stock is undervalued and represents the best use of its cash at that time. In most cases, the company’s optimism about its future pays off handsomely over time.

Share Repurchases Versus Dividends

While dividend payments and share repurchases are both ways for a company to return cash to its shareholders, dividends represent a current payoff to an investor, while share buybacks represent a future payoff. This is one reason why investor reaction to a stock that has announced a dividend increase will generally be more positive than to one announcing an increase in a buyback program.

Another difference has to do with taxation, especially in jurisdictions where dividends are taxed less favorably than long-term capital gains. Assume you acquired 100,000 shares of BB at $10 each, and you live in a jurisdiction where dividends are taxed at 20% and capital gains are taxed at 15%. Suppose BB was debating between using its $100 million in excess cash for buying back its shares or paying it out to shareholders as a special dividend of $1 per share.

Though the buyback would have no immediate impact on your taxes, if your BB shares were held in a taxable account, your tax bill in the event of a special dividend payout would be quite hefty at $20,000. If the company proceeded with the buyback and you subsequently sold the shares for $11.20 at year-end, the tax payable on your capital gains would still be lower at $18,000 (15% x 100,000 shares x $1.20). The $1.20 represents your capital gain of $11.20 minus $10 at year-end.

Although share repurchases may be better for building one’s net worth over time, they do carry more uncertainty than dividend payments, as the buybacks' value depends on the stock's future price. If a company’s float has contracted by 20% over time but the stock subsequently plummets 50%, an investor would, in retrospect, have preferred to receive that 20% in the form of actual dividend payments.

Share repurchases are a great way to build investors' wealth over time, although they come with more uncertainty than dividends.

Capitalizing on Share Repurchases

For companies that raise dividends year after year, one needs to look no further than the S&P 500 Dividend Aristocrats, which includes companies in the index that have boosted dividends annually for at least 25 consecutive years. For share repurchases, the S&P 500 Buyback Index is a good starting point to identify companies that have been aggressively buying back their shares.

Though most blue chips buy back shares on a regular basis—primarily to offset dilution caused by holders exercising their employee stock options—investors should watch for companies that announce special or expanded buybacks.

Float shrink exchange traded funds (ETFs) have also attracted a great deal of attention recently. The Invesco Buyback Achievers Portfolio (PKW) is the biggest ETF in this category. This ETF invests in U.S. companies that have repurchased at least 5% of their outstanding shares over the previous 12 months.

Article Sources
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  3. S&P Dow Jones Indices. "S&P 500 Buyback Index."

  4. Invesco. "PKW - Invesco BuyBack Achievers™ ETF."

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