The act of a company buying back stock is one of the most decisive topics in the financial world. Buying back stock with shareholder funds can be a great way to create value and increase intrinsic value per share. It can also be a good way to destroy shareholder value if repurchases are conducted at high levels. There are many examples of companies that have spent billions buying back their own stock at the top of a market, only to have to issue new shares to raise funds in a downturn.
The challenge is trying to determine if a company is creating value by buying back shares or destroying it. Working out the business' intrinsic value is the key to arriving at a conclusion for this question.
Creating or destroying value?
At the 1996 Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) annual meeting, Warren Buffett (Trades, Portfolio) offered some color on the process he used to understand if a business was creating or destroying wealth for investors when it repurchased stock.
Commenting on the process of trying to establish the intrinsic value of a business, Buffett said, "there's a lot more to intrinsic value than book value and P/E ratios. And anytime anybody gives you some simplified formula for figuring it out, forget it."
He went on to add that to assess intrinsic value accurately, one has to "understand the business." More often than not, he added, management is best placed to evaluate intrinsic value more than anyone else because they will understand their business more than anyone else.
The Oracle of Omaha also appeared to suggest that as long as a company is a "really outstanding business," it doesn't really matter how much management ends up paying for shares when they are repurchased.
"We have enormous respect for the power of a really outstanding business," Buffett said. "If a management wishes to further intensify our ownership by repurchasing shares, we applaud."
He continued to elaborate:
"So, I urge you, if you're trying to decide on the wisdom of repurchases, or of share issuances, that you don't think in terms of book value. You don't think in terms of specific P/Es. You don't think in terms of any little model. But you think in terms of what would you would really pay. Pick businesses you can understand and, then, think what you really would pay to be in those businesses. And that's what counts over time, is whether the repurchases are made at a discount from that figure."
Look past basic ratios
I think what's really fascinating about this statement is that as far back as 1996, Buffett was encouraging investors to look past basic ratios. For a man who adhered to Benjamin Graham's deep value investing style, which was entirely based around price-earnings and price-book multiples, this is notable.
But it is also interesting because sometimes it is worth paying a high price to buy a business.
Of course, that's not always the case. Still, when it comes to high-quality businesses, there is often a good argument to be made that the stock deserves to trade at a premium multiple, and they frequently do for much of their lives.
For example, when Buffett bought Coca-Cola (KO, Financial) in 1988, he was initially criticized because it was trading at a price-earnings ratio of around 14. Clearly, this figure wasn't particularly relevant to him. He could see the business was worth more than the market was willing to pay, and he wasn't going to let some arbitrary figure defined his investment style.
Unfortunately, this isn't going to be suitable for everyone. The reason why the price-earnings multiple is so widely used is that it is easily understood. Not everyone has the intellect and business mind that's available to Buffett.
Disclosure: The author owns no stocks mentioned.
Read more here:
- Charlie Munger: The Factors to Consider When Valuing a Business
- 3 Benjamin Graham Style Net Net Stocks
- The History of Charlie Munger and the Daily Journal
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