Share repurchase programs have become increasingly popular over time. They may be viewed positively by investors and company management because they reduce the number of shares in issue and improve per-share metrics such as earnings per share.
Investors may feel that improving earnings per share figures and other per-share metrics could lead to a rising stock price, since each share is theoretically worth more. Therefore, the general view of share repurchase programs seems to be fairly positive.
However, while share repurchases can sometimes be good for a company, they may not necessarily represent an efficient use of capital. This is particularly the case when a company’s shares trade on a rich valuation that is in excess of its intrinsic value. Typically, when companies repurchase shares at higher prices, it serves as a red flag.
A limited thought process
Share repurchases are typically only good for shareholders if shares are undervalued and there is no better use of capital (i.e. reinvestment opportunities). Despite this, many companies engage in share repurchase programs without considering whether their stock price offers good value for the money. Indeed, they are often focused on making up for high amounts of new shares issued as part of stock option compensation plans for top executives. Reducing the share count can also make investors think of the stock as more attractive, leading to a higher market valuation.
Berkshire Hathaway (BRK.A, Financial) (BRK.B, Financial) Chairman Warren Buffett (Trades, Portfolio) has previously discussed the problem of companies initiating share repurchases without considering whether their shares offer good value for the money. As he once said:
“Many management teams are just deciding they are going to buy X billions over X months. That's no way to buy things. You buy when selling for less than they are worth. It's not a complicated equation to figure out whether it is beneficial or not to repurchase shares.”
Running out of ideas
Of course, the issue of companies repurchasing their own shares at high prices may be particularly relevant today. The stock market’s recent rise to reach a new record level means that a relatively large proportion of company shares may trade at or above their intrinsic values. Therefore, it may not be a prudent or logical time for many businesses to initiate share repurchase programs – even though many companies are enjoying improving trading conditions that are producing growing amounts of free cash flow.
Moreover, share repurchase programs undertaken when stock prices are overvalued could even be a red flag for investors. They may suggest that the company in question does not have any better use for its excess capital. In turn, this may mean it lacks obvious growth opportunities. This could have a negative impact on its overall valuation and financial prospects over the long term.
Therefore, it may be prudent for investors add share repurchase programs, and whether they are an efficient use of capital, to the investment ‘checklist’ they consult prior to purchasing any stock. It could help them to avoid buying stocks that lack growth opportunities and have management teams that are running out of ideas regarding how to grow the business. It may also highlight holdings that could be worth selling due to their lack of long-term growth potential.
