The Dynamics of Shareholder Capital – Part II

During my career in the financial markets, it has been fascinating to see obscure financial concepts become part of mainstream discourse.

One of the biggest debates in recent years has been about share buybacks.

Before we go further, let's go through the definition of a share buyback...

Companies have a defined number of shares outstanding (for our example, let's say 100), and for publicly traded companies, those are usually free to trade.

If a company has cash it wants to spend – no matter where that cash comes from – it could go into the open market and buy some of those shares.

Let's say the stock is at $10 per share, and the company wants to buy ten shares. It would spend $100 on "buying back" those shares. The company can then "retire" these shares, leaving it with 90 shares outstanding.

The big question is, does this create any economic value?

Like most of these types of questions, there are several factors to consider...

In theory (and mostly in practice), if there's a constant demand for the shares, the share price should go higher.

Per our example, let's say 100 investors are willing to pay $10 per share, but now, there are only 90 shares available. Do the ten investors who now can't get a share (because of the retired shares) offer a higher price?

The reduction of the share count is called "shrinking the float," historically, companies that have aggressively shrunk their share floats have been outstanding stocks.

A notable example is the stock of auto repair retailer AutoZone (AZO). Look at the stock price since 1991…

Since June 1991, the company's stock price has compounded at +20.5%. This is significantly better than the S&P 500 and is a total return of 47,535%!

Next, look at AutoZone's net income since 1998…

The company has an impressive track record, growing net income more than tenfold from $228 million to almost $2.7 billion. 

Still, that's far short of the stock's growth over the same time.

However, if we look at its share count, we can see how aggressively AutoZone has been buying back the stock...

Across the period where it grew earnings by ten-fold, AutoZone also reduced its share count by almost 90%!

The net result is that its earnings per share ("EPS") soared! Look...

As you can see, EPS has gone from $1.48 to almost $144 per share or nearly +10,000%!

AZO has taken a decent growth business and harnessed its cash flow to buy back a crazy amount of stock and amplify EPS growth. This has been well rewarded in the stock market.

This is an example of a buyback that has been great for shareholders. It's one of the most successful in financial history.

Do you think share buybacks add value to a company and its stock? Let us know your thoughts in the comments section online or at [email protected].

But is this the norm? Therein lies the problem...

The first question is whether the company would have been better off investing in its business instead. Would the stock have gone even higher with even higher earnings power?

This is hard to argue because AutoZone grew its earnings tenfold in a mature U.S. automobile market.

The argument that companies are better off investing in the business is the most common criticism of buybacks. Still, it suffers from one of the greatest fallacies we see in financial analysis: that outsiders can make better judgments than management teams regarding running the business.

Management teams could be better, but most did not get there by accident. They are skilled professionals who also have much more information than any outsider.

Honestly, it is galling that financial analysts and politicians who criticize them are entirely unqualified to make these determinations. Most have never run anything, much less a large publicly traded company.

One of the best aspects of our financial system is that these companies also have a board of directors, with several of them being independent of management. Significant laws and regulations also govern these boards.

The system isn't perfect, as mistakes and even fraud sometimes occur, but overall, it works well.

"Checks and balances" are in place to ensure the interests of shareholders – and, increasingly, employees – are appropriately served.

Almost always, a company that's buying back stock would rather invest more in the business if it had the opportunity. The share buyback, however, is an accurate view of its investment opportunities.

Another criticism is that share buybacks are "financial engineering" and don't create "real" value.

Frankly, this doesn't make sense. Most aspects of running a company's balance sheet – issuing shares, issuing debt, paying debt down, etc. – are "financial engineering." And the argument about "real" value runs into our discussion above about the demand for shares.

Also, remember something that I've said repeatedly here at HX Research. Stocks are just pieces of paper. Sure, shareholders technically own the business's cash flows, but those cash flows are seldom paid to shareholders.

Shareholders see companies that successfully buy back their stock as shrinking the supply, feeding into a relatively constant demand. This should (and most often does) create buyers who are willing to pay more for the stock, and as a result, the shares go higher.

This has undoubtedly been the case with AutoZone's stock...

When properly executed, share buybacks are great for shareholders and are a strong net positive for the stock market and economy.